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Interest rate vs APR

I occasionally get the following question when borrowers are reviewing their disclosures…”I thought my rate was 2.5%, why does it say 2.55%?”

 

The reason is, the second rate is actually the Annual Percentage Rate (APR).  The APR, in this case 2.55%, is the nominal interest rate plus additional costs to secure the loan, the closing costs.

 

The 2.5% in the above example is the nominal rate, which is the rate that your loan officer will typically quote you and it’s the rate at which interest accrues on your outstanding balance.

 

Why do I care about the APR then?  The Truth in Lending Act (TILA) of 1968 mandated that lenders disclose the APR to potential borrowers.  It expresses the entire cost of the loan (nominal interest rate, term, and fees) as another interest rate to help borrowers compare scenarios.  The problem with the APR is not all lenders report the APR the same.  Here is a list of what fees typically are counted towards the APR and ones that are not.

 

Fees included typically
Discount points, pre-paid interest, admin fee, processing fee, underwriting fee, document preparation fees, PMI, closing fee.  Sometimes the application fee.

 

Fees excluded
Title fee, attorney fee, notary, recording fees, transfer taxes, credit report, appraisal fee, home inspections.  Pre-paid and escrowed taxes and insurance.
In a recent loan I originated these were the actual fees included:  administrative fee, tax service, flood certification, closing fee, closing protection letter (CPL), courier fee, tax certification fee, and pre-paid interest.  While these were not:  credit report, title examination, recording fees, lender’s title insurance.  Pre-paid taxes and insurance are also not included.

 

A quick rule of thumb is fees equaling 1% of the loan amount will result in .075% in APR at current market rates.  Here’s an example:  $400K loan amount at 2.750% with $4K in loan fees would have an APR of 2.828%.  Using a 5% interest rate would result in a 5.089% APR.  As the interest rate increase the effects of fees on the APR also increase.

 

Lastly, the length a borrower keeps the loan will also affect this calculation.  The shorter you stay in the loan the greater affect the fees will have.  Today’s disclosures also give a five-year cost of the loan to help compare.

 

The APR…exciting stuff!

 

– Jim White
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