Why APR Doesn’t Match Your Interest Rate

mortgage calculator“Why is the APR higher than the interest rate? Is this a rip-off?” This is a question I’m frequently asked, and one that is important to understand.

APR stands for Annual Percentage Rate. The APR is not the same as the interest rate you pay on your monthly mortgage payment.

The APR is the interest rate plus some of the fees. Fees that should be included in the APR are the following:

* Mortgage insurance

* Discount points, if you are buying down the interest rate

* Origination fees, lender fees (some but not all)

* Most other closing costs (some but not all)

And there is the problem: “some but not all”

Lenders disagree on exactly which closing costs should be included in the APR calculation. For example, most lenders will not include the Document Preparation Fee–a bogus, unnecessary, double-charge junk fee. This throws off the accuracy of the APR.

When I worked as a mortgage broker, one of my clients called to say he was dropping the loan and switching to Bank of America midway through the process. When I asked why, he said, “Their APR is lower.” I didn’t believe it and asked him to bring in the Good Faith Estimate and Truth-in-Lending from BOA so we could do a side-by-side comparison.

Sure enough, even though we both had the same interest rate, BOA was charging more in fees and yet showed a lower APR. I pointed this out and showed him the check-boxes that indicated which fees were included in their APR calculation.

That was his “aha moment.” He saw that they were sneakily not included all their lender fees in the APR.

I read a quote–INACCURATE AND FALSE–by an economics professor at Westmont College in Santa Barbara, CA. David Newton said about APR, “It’s the one common denominator by which you can compare loans side by side, comparing apples to apples to apples.” But that is not true. The problem is that Newton has never worked as a loan officer, so although he understands the mathematics of how APR is supposed to work, he doesn’t know that plenty of banks and mortgage lenders have their own tricky and deceptive ways of showing their APR. (This is why I wrote in a blog post a few weeks back that you need to be careful who you take mortgage advice from. Being smart doesn’t mean you understand what’s going on in the mortgage business.)

You do not compare APR in order to figure out the cheapest loan. Instead, you look at the interest rate and all of the lender fees and the fees the lender controls. Lender controlled fees are the third party costs charged by vendors chosen by the lender. These are four: credit report, appraisal report, flood cert., and tax service.

One lender will charge $15 for a credit report, and another lender will charge $75 for a credit report (as I saw last week). Clearly, the lender charging $75 is padding the cost. You want to include this third party cost when comparing costs and choosing your lender.

You do not include the title insurance, attorney fee, escrow settlement fee, or county recording fee when comparing loan offers, because the lender has nothing to do with those fees. They set their own fees. In addition, you choose your own title company and attorney or escrow agent. So that is up to you, not the lender.

How I View APR When Comparing Loans

If I see an APR on a conventional loan that is significantly higher than the interest rate, that is a red flag that tells me the lender fees are probably high and might include unnecessary junk fees. But if it is an FHA loan, I know the APR is going to be significantly higher due to FHA’s upfront mortgage insurance premium.

So overall, I don’t pay much attention to the APR. It is more accurate to compare loans by looking at the actual interest rate and all of the lender fees and lender-controlled fees instead.

As always, your comments are welcome. The comment tab is at the right top of the blog post.

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