APR and FBI, CIA, USDA, FDIC, ATF, USPS, SEC, NASA, HUD. A lot of terms and abbreviations these days seem like alphabet soup! Interest Rate and APR (Annual Percentage Rate) are two of the most commonly confused terms in the mortgage business.
APR is a measure of closing costs, not monthly payment
Many people think APR is the rate of interest that you pay on the loan. But the interest rate is actually the rate of interest you pay on the loan. If you get a loan with an Interest Rate of 5.00%, your monthly payments are calculated at 5.00%. Your APR has no bearing on the interest collected or the monthly payment.
Technical definition of APR
The technical definition of APR is: A uniform measurement of the cost of a loan including interest and finance cost of closing, expressed as a yearly interest rate. Huh?
APR is supposed to reflect what your closing costs are if they were built into the interest rate. APR is supposed to be a way for the consumer to measure closing costs. It tells you if you are getting gouged on closing costs. For example: assume a lender quoted you a great 5% rate with a 5.89% APR. You are likely paying discount points and possibly some outsized closing costs. If you get quoted a 5% Interest Rate and the APR is 5.039%, then the loan likely has acceptable closing costs and zero discount points. So the APR is an abstract figure. It is not the actual rate you pay. Does that make APR more clear?
Below is a chart that may help even more:
Fees–APR–Interest Rate–Monthly Payment
$0,000, 4.500%, 4.500%, $1,048.21
$1,500, 4.597%, 4.500%, $1,048.21
$3,000, 4.702%, 4.500%, $1,048.21
$4,500, 4.808%, 4.500%, $1,048.21
Notice that the APR rises as the fees rise. But the monthly payment and the Interest Rate never change.
Lenders calculate APR in slightly different ways…confusing!
Further, different lenders will input different fees into their APR calculations. Some may count some fees that others do not. I personally think APR is a poor measure of closing costs. The best way to measure closing costs between lenders is to look at itemized Loan Estimate worksheets and compare costs on each line item.
Many fees do not vary from lender to lender
You also need to be aware that title company fees, title insurance, per diem interest, and property tax escrows will not vary lender to lender. Different lenders may estimate a different number of months of taxes to collect for the escrow account. But that has no bearing on what may really be collected at settlement.
So there is only a need to compare lender fees. Another example is that a title attorney fee may be estimated at $600 by one lender and $400 by another. But if the fee is actually $500, both lender’s estimates will not be exact and the lender that estimated $400 will appear to have the cheaper fees. But the lender does not dictate a title company’s fees. So choosing the lender that had the $400 estimate may be a big mistake!
And knowing the price of everything and the value of nothing is not a good way to shop.
The bottom line is to take a hard look at your Loan Estimate. And most importantly, work with very experienced lenders who come referred. They will do all that they can to quote accurate fees and keep their reputation intact.