Understanding APR and the Annual Percentage Rate

Two numbers appear on a mortgage quote, and they are easy to confuse. The interest rate is the price of borrowing the money. The annual percentage rate is the price of borrowing the money plus the cost of arranging the loan, expressed as a yearly rate.

On a mortgage with a single origination charge, the two are close. On one with several fees, they can be a long way apart.

What goes into the APR

The APR bundles the interest rate with the costs of obtaining the loan. In practice that means things like:

• The origination charge
• Application and underwriting fees
• Third-party fees such as the appraisal and the title work
• Mortgage insurance, where it applies
• Certain government charges

The formula is set out in federal regulation, which matters for one important reason: it means two lenders quoting an APR are quoting it the same way, so the numbers can be compared directly.

How it is calculated

The APR is the discount rate that would produce the same total of payments over the life of the loan as the loan’s actual cash flows, once the fees are included. In other words, it answers the question: if the fees had been folded into the rate instead of charged separately, what would that rate have been?

That construction has a useful consequence. Because the fees are spread across the whole life of the loan, their effect on the APR is smaller when the loan is long and larger when it is short. The same $4,000 of fees moves the APR by more on a 15-year loan than on a 30-year one.

The trap of the low-rate offer

Here is the pattern that catches people. A quote comes in with a rate below the going market rate and a set of fees that are higher than the rest of the market. The headline is the rate, and the rate is the smallest number on the page.

The APR is what exposes the trade. A rate that is 0.5 percent lower with $4,000 of extra fees can easily carry a higher APR than a rate 0.5 percent higher with no extra fees. Neither offer is wrong; they are two different structures, and the APR is the number that puts them on the same scale.

What the APR does not tell you

The APR is a cost measure, and it has limits that matter when comparing offers.

It does not set the payment. The monthly payment comes from the interest rate and the term. Two loans with identical APRs and different rates have different payments and different totals.

It does not capture the cash to close. The APR is a rate, and the out-of-pocket amount at closing is a separate figure. A loan with a lower APR and a large cash requirement is not comparable on the APR alone.

It does not capture a shorter term. A 15-year loan with a good APR has a very different cash-flow profile from a 30-year loan with the same APR.

It assumes the loan runs its full term. If a loan is paid off early, the APR overstates the cost, because the fees are amortised over a period that did not happen.

Discount points

A discount point is one percent of the loan amount paid at closing in exchange for a lower rate. It is the standard way of trading a fee for a rate, and it makes the APR comparison more useful, because the trade is already inside the APR.

Whether the trade works out is arithmetic. A point that buys a quarter of a percent needs enough time to be repaid for the rate reduction to exceed it, and the break-even calculation is a simple one. The mortgage payment calculator can run both sides of it: change the rate and add the point as a fee, and read the total interest in each case.

Where to find the reference rates

Freddie Mac publishes the Primary Mortgage Market Survey, which is the benchmark most often used as a reference point, and Fannie Mae publishes equivalent research and commentary. Neither is a quote; they are the market context against which a quote is read.

A practical order for comparing

1. Put both offers on the same term and the same loan amount.
2. Compare the APR.
3. Then compare the cash to close, because the APR says nothing about it.
4. Then run both through the payment calculator and compare the payment, the total interest and the payoff date, because those are what the loan actually does.