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- Annual Percentage Yield – APR
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In comparing any type of loan, whether it be a fixed rate loan to a fixed rate loan, adjustable rate loan to adjustable rate loan or fixed rate loan to adjustable rate loan, there is one way that can be used to compare apples to apples and even apples to oranges.
APRs are designed to do just that. APRs are a way to calculate the annual cost of loans, taking into consideration loan origination fees (points) and the other costs associated with securing a loan. The additional costs include appraisal and credit report fees as well as processing and document fees.
One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Regulation Z (Reg Z, the mortgage companies disclosure of cost for the loan) is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation. For our illustrations we will use only the points, appraisal, credit report, processing and document fees.
As a means of protecting consumers from companies who did not disclose the fees associated with a particularly low start rate on an adjustable rate loan or below market rate on a fixed rate loan, APRs give consumers a way to check the true cost of a loan. One common situation that occurs when a borrower receives a Reg Z, and a copy of their note, is the column that indicates the amount financed is less than the loan amount the borrower is actually financing. It is here that many borrowers leap before they look and call to find out why they are only receiving a $147,461 loan when they applied for a $150,000 loan. It is here that APRs enter the picture.
Let’s look at how APRs are calculated. For our illustration we will assume a 6.50% fixed rate interest. For a 30 year loan the monthly payments for a $150,000 loan are $948.10. In order to calculate the APR for this loan we subtract $1,500 (1% origination), $400.00 appraisal fee, $20.00 credit report fee, $550.00 underwriting fee, $69 tax service fee and other fees. ($150,000 – $2,539= $147,461). The $147,461 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $147,461 loan with the same payment of $948.10, the APR is calculated as 6.67%.
How does this compare to a 30 year fixed rate loan with a 5.875% interest rate and 2.5 points? The monthly payments for this loan is $887.31. In order to calculate the APR for this loan we subtract $3,750 (2.50 points), $400.00 appraisal fee, $20.00 credit report fee, , $550.00 underwriting fee, $69 tax service fee and other fees. ($150,000 – $4,789 = $145,211). The $145,211 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $145,211 loan with the payment of $887.31 the APR is calculated as 6.178%.
So, the upfront cost to “buy down the rate” in the second scenario is somewhat justified. The result to the customer is a higher up front cost, but lower payment, which in this case is reflected in the lower APR for the second scenario.