You may find the Annual Percentage Rate (APR) on a mortgage loan a confusing aspect of the home financing. You can find the loan APR listed on the Truth in Lending (TIL) disclosure. The disclosure lists the APR figure as a rate. However, be sure to note that is not the interest rate on the loan. Once you learn to understand the meaning of APR, it can be a useful tools when shopping for a loan. It will also help you to understand the true cost of a mortgage.
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How Do You Calculate the APR?
The formula that determines an APR looks at the closing costs on the loan. Those costs are annualized over the entire term of the loan. Divide the closing costs by 30 for a typical 30 year fixed mortgage loan (or 15 for a 15 year loan). Add that amount to the note interest rate to get your APR. A mortgage with a note rate of 4.25% might have an APR of 4.45%, as a typical example.
Knowing how to calculate an APR will allow you to compare loan options more accurately. Say the lender gives you the option of a “no-fee” loan at 4.5%, along with the option above. The APR shows that the first option, with the closing costs, is a slightly cheaper loan in the long run. On a true “no-fee” loan, the Annual Percentage Rate will be exactly the same as the interest rate. Check your TIL disclosure to make sure it is, if that is what you have agreed on with your lender.
If the loan terms include mortgage insurance, the APR calculation will also add in the MI premium. Mortgage insurance becomes necessary when you buy a home with less than a 20 percent down payment. A loan with a 4.25% note rate, which has a mortgage insurance factor of .75%, will have an APR of at least 5%. This is before including closing costs.
APR Only Applies at the Beginning
The APR figure is never something you actually pay on your mortgage loan. The APR works only as a comparative tool up until closing, which is when you pay the APR. After that, your note rate is what you pay for the remaining life of the loan. This differs from the way APR works on some other credit accounts, like credit cards, which may have an annual fee. If you refinance your loan down the road, compare your new loan terms to the interest rate on your old loan, not the original Annual Percentage Rate.
Sometimes it does make sense to take a mortgage with a higher APR. This could minimize your fees. That could be an option if you expect to pay off your loan before the scheduled end date, either through refinance or sale. Let’s go back to the above scenario. The “no-fee” option at 4.5% makes for a better choice if you plan to pay off the loan in less than ten years.
You can certainly use the APR to help determine the best mortgage loan for your needs. However, it should not be the only defining factor. Don’t forget to consider the note interest rate, loan length and actual loan costs when shopping for a mortgage. Combined with these factors, the APR helps give transparency to the loan terms.
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