| Calculating the interest rate
of your mortgage or other loans can be very confusing. With
variations in compounding, terms, and other factors, it's hard
to compare apples to apples when comparing mortgages.
Sometimes it seems like we're comparing apples to grapefruits.
For example, what if you want to compare a 30-year fixed-rate
mortgage at 7 percent with one point to a 15-year fixed-rate
mortgage at 6 percent with one-and-a-half points. First, you
have to remember to also consider the fees and other costs
associated with each loan. How can you accurately compare the
two? Luckily, there is a way to do that. Lenders are
required by the Federal Truth in Lending Act to disclose the
effective percentage rate as well as the total finance charge
in dollars.
The annual percentage rate (APR)
that you hear so much about allows you to make true
comparisons of the actual costs of loans. The APR is the
average annual finance charge (which includes fees and other
loan costs) divided by the amount borrowed. It is expressed as
an annual percentage rate -- hence, its name. The APR will be
slightly higher than the interest rate the lender is charging
because it includes all (or most) of the other fees that the
loan carries with it, such as the origination fee, points, PMI
premiums, etc.
Here is an example of how the APR works:
Suppose you are shopping for a mortgage and see an
advertisement for a lender that is offering a 30-year
fixed-rate mortgage at 7.0 percent with one point. You also
see an advertisement for another lender that is offering a
30-year fixed-rate mortgage at 7.0 percent with no points.
That would appear to be an easy comparison, right? Actually,
it isn't. You have to dig deeper than that. Fortunately, the
APR eliminates the need for you to do any digging at all.
Let's look at how the APR is calculated:
Say you're financing $100,000. With either lender, that
means that your monthly payment is $665.30. If the point is 1
percent of $100,000 ($1,000), the application fee is $25, the
processing fee is $250, and the other closing fees total $750,
then the total of those fees ($2,025) is deducted from the
actual loan amount of $100,000 ($100,000 - $2,025 = $97,975).
This means that $97,975 is the new loan amount used to figure
the true cost of the loan. To find the APR, you determine the
interest rate that would equate to a monthly payment of
$665.30 for a loan of $97,975. In this case, that is 7.2
percent. |
If Lender 2 charges an
application fee of $45, an origination fee of 3 percent
(because it's cash you pay at closing, it's the same as points
if it's expressed as a percentage of the total loan, but it's
not always advertised that way), and other fees that total
$775 at closing, then the total of those fees ($3,820) is
deducted from the actual loan amount of $100,000 ($100,000 -
$3,820 = $96,180). To find the APR, you determine the interest
rate that would equate to $664.30 for a loan amount of
$96,180, which in this case is 7.39 percent. So there you have
it! Although Lender 2 advertised no points, because it charged
an origination fee it didn't really offer the best deal. Ask
for the APR and compare with other lenders. Also, make sure
you know which fees are being included in the APR calculation.
Typically, these include: origination fees, points, buydown
fees, prepaid mortgage interest, mortgage insurance premiums,
application fees, underwriting, etc. -- any fees that are
coming directly from the lender, but not fees that you would
have to pay using any lender, such as title insurance,
appraisals, etc.
Remember those algebra classes back in high school?
Well, luckily you don't have to! You won't have to calculate
the APR on your own -- the lender will give it to you when it
gives you the Federal Truth in Lending Disclosure; you just
have to understand its importance.
Here are some other things to consider when you look at
the APR.
 | The more you are financing, the less impact all of
those fees will have on the APR, simply because the APR is
calculated based on the total loan amount. |
| The length of time you are actually in the home
before you sell or refinance has a direct influence on the
effective interest rate you ultimately get. For example, if
you move or refinance after three years instead of 30, after
having paid two points at the loan closing, your effective
interest rate for the loan is much higher than if you stay
for the full loan term. |
|
Equal Housing Opportunity
