Understanding the Annual Percentage Rate

The Annual Percentage Rate, or APR, is a tool consumers can use to compare rates from one lender to the next. While the note rate on a mortgage, the rate used to calculate the monthly payment, is certainly important, just as important is the APR. Unfortunately, it’s a misunderstood number by many and even individual loan officers have trouble explaining what the APR is and what it isn’t.

The APR is prominently displayed with a lender’s Cost Estimate, so much so that consumers who first review the loan disclosures think the APR is the note rate. Unless the loan officer clearly explains what the APR is at the outset, confusion can set in and it’s also very possible the consumer thinks it’s a ‘bait and switch’ strategy. Someone can get a rate quote for, say, 3.00% and after disclosures are provided to the consumers, the APR might read 3.15%. It’s the note rate that determines the monthly payment, along with the loan term and loan amount. The APR is designed to let consumers easily compare loan offerings from one lender to the next.

Yet the APR sometimes confuses more than explains. Simply put, the APR is the cost of money borrowed expressed as an annual rate. Used properly, consumers can properly compare. A lender with higher loan costs will show a larger disparity between the note rate and APR. For instance, three lenders show a note rate of 3.00%. Lender A also shows an APR of 3.10%. Lender B 3.15% and Lender C 3.19%. In this example, Lender A appears to have the better offering because the difference between the note rate and APR is relatively small compared to Lenders B and C.

The APR includes different loan fees, but the APR can also change based upon which day of the month the loan closes. How so? The APR also includes prepaid interest charges. Prepaid interest is the per diem amount from the day the loan closes to the first of the following month. If the loan closes on the 20th of the month, that would then mean 10 days of prepaid interest. Lenders will collect this amount along with other loan fees at the settlement table.

If the loan closes on the 30th of the month, there would be just one day of prepaid interest. This is in essence the very first mortgage payment. Interest on mortgage loans is calculated in arrears. It’s the opposite of rent. A rental payment is made to pay for the month you’re about to live in whereas a mortgage payment calculates accumulated interest from the previous month. The mortgage payment on the 1st of the month is for accumulated interest from the previous month. Closing on the last day of the month the APR will be lower with just one day of interest included compared to 10.

When comparing lenders, the closing costs are just as important as the rate. Someone can offer a 30 year fixed rate at 3.00% and $1,000 in fees. Another lender might also offer a 30 year fixed rate at 3.00% but with $5,000 in fees. In this way, it’s pretty clear which lender is quoting the more competitive loan terms. When explained in this manner, the differences in note rate and APR are made clear.

Don’t let a loan officer tell you that the APR isn’t important. And as far as the monthly payment is concerned, that would be correct. What is important is to get a snapshot of lender fees along with the note rate. The APR does just that.

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