Annual Percentage Rate: A good indicator of borrowing costs

Annual Percentage Rate is not the rate which is advertised by the lender. Rather it is an effective rate that reflects the costs of a loan. APR is calculated by taking into consideration the rate of interest on the mortgage loan as well as the closing costs. Home buyers can get to know the APR by taking the help of an APR calculator. APR can be effectively used to make a comparison of different lenders as well as the loans offered by them.

Some of the fees and costs that are included in APR are listed below:

• Discount points
• Origination points
• Underwriting fees
• Loan processing fees
• Document preparation fees
• Title fees
• Prepaid interest
• Private mortgage insurance
• Attorney fees

APR should not be treated as the sole factor to make mortgage comparisons. To compare mortgage offers, various factors that should be taken into consideration are – mortgage rate of interest, closing costs and lender fees. Here, it is to be noted that the lender fees may sometimes be used to lower down the mortgage rate of interest.


Here's an example, which helps you understand why you should not rely solely on APR to compare mortgage loans. Let's consider two 30-year fixed rate mortgage loans - A and B - with loan amount $180,000 each.


Details of loan A

Loan amount=$180,000
Interest rate=6.25%
APR=6.50%
Lender fees=$4500


The loan amount financed=$180,000 - $4500=$175,500


The monthly payment amount by using the FRM calculator =$1108.29



Details of loan B

Loan amount=$180,000
Interest rate=6.50%
APR=6.70%
Lender fees=$1000


The loan amount financed=$180,000 - $1000=$179,000


The monthly payment amount=$1137.72


So, the difference between monthly payments in loan A and loan B is=$1137.72 - $1108.29=$29.43


Here, it is to be noted that the APR of loan A is lower than the APR of loan B, but to obtain loan A, you have to pay additional $4500 - $1000=$3500 as lender fees. In other words, by opting for loan B, you can save $3500 in lender fees.

If you go for loan A, you have to however pay $29.43 less as monthly payment. To recover $3500, time required will be 3500/29.43= 119 months or 9.9 years. If you have plan to sell the house within next 9.9 years, then you will not able to recover the costs and loan B will be suitable for you. In other words, in such case even a loan with higher APR will be suitable for you. Again, if you don't have any plan to sell the house within 9.9 years, then loan A will be suitable for you.

APR is a good indicator of the costs of a mortgage loan but it has some downsides too. Here are few drawbacks of APR-

• APR is a percentage rate. It does not give the costs of a mortgage in absolute figures. But, the borrowers have to pay some costs upfront. Due to this, APR may sometimes be little confusing to the home buyers.
• At the time of calculation of APR, it is assumed that the you pay off the mortgage loan through normal amortization. But, in actual practice, you may pay off the mortgage early or you may refinance the mortgage too. Calculation of APR does not take these possibilities into consideration.
• At the time of estimating the APR of a loan, it is assumed that the rate of inflation is zero over the entire loan term. In turn, this means that the value of dollar remains unchanged throughout the loan term. But, in reality the rate of inflation does not remain unchanged over the entire loan term.

Despite these drawbacks, APR gives a fair idea about the costs of a mortgage loan and borrower should have a look at this before finalizing a mortgage deal.