What is APR?
APR, or Annual Percentage Rate, is a tool that allows borrowers to more easily compare the cost of the loans they are considering using to purchase their home. APR combines both the interest that will be paid annually as well as the cost of getting the loan initially. For example, one lender may offer a loan to you at a lower interest rate but have higher discount points and fees while another lender will offer a loan with a higher interest rate but lower discount points and fees. The APR is used to help you decide which loan will be better for your specific situation in the long- and short-term.
Why use APR?
Anyone who has ever applied a loan knows that the terms and conditions can be confusing. In order to reduce this confusion among borrowers, the US Government passed the Truth in Lending Act. One of the provisions of this act is that lenders must quote the APR to every potential borrower. The APR makes it easier for borrowers to compare loan offers and make an educated decision on what the best option is for them.
How Does it Work?
Since APR is a way of helping you decided which loan is best for you, it is important to understand how it works. The best way to understand how APR works is to understand how it is calculated. To calculate APR follow these three steps:
1. Add the points to the loan amount to get an Adjusted Balance.
2. Find the monthly payment on the Adjusted Balance.
3. Return to the original loan amount, and find the interest rate that would result in the monthly payment found in step 2. This is the APR.
As these steps can seem a bit foreign to those not well versed in finance, the process can be simplified by using an example. For our purposes, we will compare two different loans to help you see how different interest rates and and fees affect the cost of the loan.
For this example, we will compare two quotes for $150,000 mortgages, each for a 30-year term:
Lender A offers an interest rate of 6.5 percent with the borrower paying no discount points and $5,000 in fees;
Lender B offers an interest 6.25 percent with the borrower paying 1 discount point ($1,500) and $5,500 in fees, for a total of $7,000 in points and fees.
Lender B offers a lower interest rate (or "nominal rate"), but for $2,000 more in points and fees.
So which is a better deal? Calculating the APR can be used to give you a better idea.
Lender A's offer has an APR of 6.83 percent, while Lender B's offer has an APR of 6.71 percent. Since Lender B's APR is lower, that loan is a better deal in the long run.
However, you must also consider the short-term, which may make Lender A’s offer more appealing. Although Lender B’s offer is better in the long-run, it may be difficult to come up with the difference of the initial fees ($2000).
You must also take into consideration how long you plan on remaining in the home. Loan A costs $948.10 a month in principal and interest -- $24.52 a month greater than Loan B. So with Loan B, you pay $2,000 up-front to save just under $25 a month. At that rate, it will take 82 months, or over 6.5 years, before you recoup the $2,000. If you sell the house in less than 82 months, Loan A is the better deal for you.
All of these factors, as well as any other personal factors, need to be taken into account when deciding on a mortgage. Use this resource as well as the others on California Mortgage Direct to make the best decision for your home mortgage. If you have any further questions about anything you have read, please feel free to contact us at any time!