APR stands for Annual Percentage Rate. It is also one of the most misunderstood numbers when people apply for loans.

The intention of figuring the APR is to allow an apples-to-apples comparison of two loans. As consumer loans in general, and mortgages in particular, became more complicated, it became necessary to easily describe the full cost of a loan and communicate it to potential borrowers. The attempt is to help people compare similar loans from different lenders and to explain the ultimate cost of credit. The APR is defined as the cost of credit to the borrower in relation to the amount borrowed, expressed as a yearly rate. It is a number required by the Federal Truth in Lending Act, Regulation Z. 

After you apply for a mortgage, you will be sent the Federal Truth in Lending Disclosure form. At the top of the page, you will see multiple numbers. Two of these numbers are the Interest or Note Rate, the actual rate used to calculate your monthly payments, and the Annual Percentage Rate (APR). The Annual Percentage Rate will most always be slightly higher than the note rate because the APR includes other items associated with obtaining a mortgage. 

Do you need an interest rate to get a mortgage? Of course you do, but you also need other things. Origination fees, points, mortgage insurance premiums, inspections, prepaid interest, and other items may also be required to obtain a mortgage. If so, these things need to be included when calculating the APR.

Why is the APR useful? Here's an example: XYZ Bank offers a 30 year fixed mortgage for 8.00%. ABC Bank offers a 30 year fixed mortgage for 7.00%. An easy choice, right? Maybe. 

Before lenders and mortgage brokers were required to state the APR, it was hard to tell. ABC Bank has the lowest interest rate (note rate), but neglected to mention a few other items. There were also 7 points, an origination fee, and mortgage insurance required. XYZ Bank has no points, no origination fee, and just prepaid interest (your first months house payment). On a $100,000 loan, ABC Bank charges an additional $10,000, when compared to XYZ Bank's fixed rate loan. You can save an additional sixty-eight dollars per month with ABC Bank's mortgage, but you have to pay $10,000 for the privilege. The $10,000 is included in the calculation of the APR because it is a cost associated with obtaining the loan.

Here's another example: Mr. and Mrs. Smart want to buy an $85,000 home. The developer of the project they really like has a home and offers an interest rate similar to what they could get at Seven Seas Mortgage. The developer offers 6.00% fixed with no points. Lightning Mortgage also quotes 6.00% with no points, but has an origination fee equal to 1 percent of the loan amount

But wait! The Developer failed to disclose that there is a 2 percent origination fee! What looked like a better deal at the developer's lender turned out to be higher. If the APR's were given, it would be evident.

In this instance, the APR for the developer would be 6.189% and Lightning Mortgage's APR calculates to 6.094% due to the higher fees charged by the developer. Even though the note rate (the rate used to figure monthly payments) was the same, it cost more at the developer. Therefore, Mr. and Mrs. Smart (the name is more than just a coincidence) chose the mortgage from Lightning Mortgage.

Remember, the higher the loan amount, the less impact additional fees or points will have on the APR Why? If you obtain a mortgage with $2,000 of closing costs and you borrow $10,000, then the $2,000 will be nearly 20% of the loan amount. This increases the cost of your money dramatically. Usually home equity or home improvement loans show a higher disparity between note rate and APR because of this. Likewise, if you borrow $100,000 and have $2,000 of closing costs, the fees won't make as significant an impact on the cost of funds.

But what about the fees used to calculate the APR? Are there some fees that are excluded from the calculation? As a general rule, any fees that are normally used in connection with financing should be included in the APR calculation. Other fees, such as title insurance and escrow, are not included in calculating the APR The idea here is that these other fees are not coming from the lender, and they would be charged anyway, although in the real world, this also may not be true. When you compare APRs, ask the lender which additional fees are included when calculating their APR If they don't know the answer, you may want to find a lender that does know. APRs are ways of helping the consumer determine the best loan.

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