Annual Percentage Rate (APR) Calculation

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The concept of APR is a good idea. The Federal Truth in Lending law requires lenders and brokers to disclose the APR when they advertise a rate. It is designed to represent the true cost of the loan to the borrower, expressed in the form of a yearly rate. The objective of the law is to enable consumers to compare loans across different programs while forcing unscrupulous lenders and brokers to disclose their fees and upfront costs. In reality, this goal is unobtainable for several reasons. Let me explain.

The U.S. Department of Housing and Urban Development (HUD) defines Annual Percentage Rate (APR) as "A measure of the cost of credit, expressed as a yearly rate. It includes interest as well as 'other charges.' Because all lenders follow the same rules to ensure the accuracy of the annual percentage rate, it provides consumers with a good basis for comparing the cost of loans, including mortgage plans."

1st Problem:

All lenders/brokers DO NOT calculate APR the same, because HUD's rules are ambiguous to say the least. HUD does not define "other charges" implicitly.

2nd Problem:

Comparing Like to Like Mortgage Loans
ASSUMING 2 lenders (or brokers) are factoring the same "other charges" into their APR calculation, a like-kind loan could be accurately compared (e.g. a 30-year fixed versus a 30-year fixed, or a 15-year fixed to a 15-Year fixed). Comparing a 30-year fixed with a 15-year fixed can also be done, but you need a, perhaps not so obvious, piece of information. If both loans have the same interest rate, the 15-year loan would have a higher APR because initial points, prepaid interest and other loan costs are amortized over 15-years versus 30-years.
Comparing Like to Unlike Mortgage Loans
- Adjustable Rate Mortgages (ARMs) have other issues. An ARM is variable and tied to a market index; the index is assumed to never change. Obviously this is an invalid assumption that can result in a figure, which again cannot be compared from one lender to another.
- Another assumption that the APR calculation makes is that all indexes are created equal. The volatility of different ARM indexes vary greatly. For example, the LIBOR (London Interbank Offered Rate) index is much more volatile than a COSI (Cost of Savings Index). An index such as the MTA (Monthly Treasury Average) averages the actual index over 12-months versus a LIBOR which is not averaged.

3rd Problem:

An APR will tell you nothing about balloon payments, prepayment penalties or how long your rate is locked for.

Conclusion:

An Annual Percentage Rate (APR) is a useful guideline to shop for loans, but you should not depend solely on the APR in choosing which loan is best for your needs.

The Calculation

The State of Texas, in its wisdom, is one of the few states that have, at least in Texas, put the "other charges" mystery to rest. They have defined APR to include the following:

Recurring Charges
- Amortization Schedule (interest, life of loan)
- Interest (prorated at closing)
- Mortgage Insurance Premiums
Non-Recurring Charges
- Application Fee
- Assignment Fee
- Assumption Fee
- Commitment Fee
- Courier Fee
- Escrow Waiver Fee
- Flood Cert Fee (with life of loan)
- Funding Fee
- Inspections for Construction
- Lender's Inspection Fee
- Loan Discount Fee
- Loan Origination Fee
- Mortgage Broker Fees
- Mortgage Insurance
- Per Diem Interest
- Processing Fee / Administration / Underwriting
- Recording Fees
- Settle / Closing Fees / Escrow
- Tax Life of Loan Certification
- Tax Service Fee
- Title Endorsement Fees (but NOT Title Insurance)
- Verification Fee (cost to verify info)
- VA Fundng Fee
- Wire Transfer Fee

State of Texas - Source Page

The above fees are converted into an annual interest rate by spreading them over the life of the loan and adding that rate to the note rate on your mortgage to arrive at an Annual Percentage Rate (APR), which is greater than the "interest rate" (i.e. note rate) unless you are doing a No Cost Refinance.