The annual percentage rates (APR)

This is mandated by the Congress of the United States to be given us, the borrowers, in our disclosure documents prior to and upon closing of a mortgage loan. Yet, even the most astute mortgage professionals have only a cursory knowledge of this important measuring device. The industry, as a whole, knows little about how the mathematics of this measure actually works or how a higher interest rate with less in fees could actually be the better loan.

The first question that should be asked of a lending source, whether you are dealing with a mortgage broker or a mortgage lender, should be "What is the annual percentage rate?" and not "What is the interest rate".

Let's discuss what APR was meant to disclose and how it should be used. Let's start with a hypothetical mortgage of a 7.00% - 30 year mortgage of $100,000 that has an origination fee (commission) of 1&1/2 points (1&1/2% of the loan amount or in this example $1,500) and other fees of $2,500. Sound pretty good? The APR is 7.409%. What happened to the 7.00%?

Mortgage Math

You are paying $4,000 to borrow $100,000. In effect you are only getting $96,000, but will pay back the full $100,000 with interest.

Another way to look at understanding the annual percentage rate is: The $4,000 of fees in the above example divided by 30 years is $133.33 per year of additional interest . What happens if we pay this loan off in 5 years? The APR jumps to 7.998%. The fees we pay are spread over fewer years, increasing the costs per year. The $4,000 in fees divided by 5 years sky rockets to $800 per year of additional interest .

See if you can guess which is the lowest cost loan:

Example # 1 - 30 year fixed rate loan at 6.875% with 2 & 1/2 points origination fee and additional fees of $2,443

Example # 2 - 30 year fixed rate loan at 7.000% with 2 points and additional fees of $1,943

Example # 3 - 30 year fixed rate loan at 7.125% with 1 & 1/2 points and additional fees of $2,143

The correct answer is Example # 1 with an APR of 7.381%. Example # 2 and Example # 2 had APRs of 7.403 and 7.500 respectively.

Now let's apply some reality to the above examples. Fewer than 5% of all 30 year mortgages are kept 30 years. What if this loan is paid off in 5 years?.

Give up? Example # 2 with an APR of 7.984% #1 had an APR of 8.113% and #3 8.035.

When you next shop for a mortgage, what is the first question you should ask? And if THEY can't answer, before hanging up, tell THEM that "the APR is the measure of all of the costs of a mortgage expressed as an annual percentage rate".