The APR is disclosed on mortgage lender advertisements and on all initial and final loan disclosures during a purchase or refinance transaction.  So, why does it have to be disclosed, why is it usually higher than the quoted interest rate, and why does it matter?

The disclosure of the APR started in 1968 with the Truth in Lending Act (TILA) and was implemented in 1969 with Regulation Z of the TILA.  Prior to the enactment of TILA, interest rates and credit terms were disclosed in different ways by lenders and creditors with no standard format.  These disclosures did not provide home buyers a standard way to compare rates from one lender to another. 

The intent of TILA and Regulation Z is to prohibit unfair and deceptive lending practices, provide an industry standard format for lenders to disclose interest rates and terms, and give home buyers an easier method of comparing the offers from competing lenders.

As a result of these regulations, all mortgage lenders must disclose the APR any time they are advertising an interest rate whether in print, media, internet, television, or radio.  The APR is also disclosed on the Loan Estimate, provided by your lender within 3 business days of completing a full loan application and on the Closing Disclosure, provided to you at least 3 business days prior to loan closing/consummation. 

In my experience, most lenders do not adequately explain what goes into the APR and what it means to you.  Next time you see a commercial or other advertisement from a mortgage lender, take note of the APR, which is usually higher than the quoted interest rate in the advertisement.  But why?

The APR was historically used by home buyers to compare lenders as it represents the total cost of obtaining mortgage financing.  The quoted rate/Note rate, is the rate used to calculate your monthly payment.  Once you have obtained the mortgage loan, the APR is no longer a relevant measure of costs as your payments are not based on the APR but on the Note rate. 

The APR is essentially the Note rate plus the cost of obtaining that interest rate. Here are the items typically included in the APR calculation:

• Loan origination charges
• Loan discount points (optional cost to “buy” the interest rate lower)
• Pre-paid interest
• Upfront mortgage insurance premium to FHA and USDA (if applicable).
• VA Funding fee (if applicable)
• Private mortgage insurance (PMI) – estimated based on down payment and number of years until it can be removed – if required for your loan.
• Charges by settlement/closing agents (typically escrow, title companies, or attorneys) if the lender requires the third party service in order to complete consummation of the loan.

That is why the APR is usually higher than the Note rate.  If there are no closing costs or fees, due to the lender or seller paying all of your closing costs, then the APR would be the same as your loan Note rate.  The APR will never be lower than the Note rate.

In my opinion, the APR is not a great tool to compare lenders and make important decisions in your home purchase.  When comparing advertised rates between lenders, here are the basic characteristics typically used to calculate the interest rate:

• Owner occupied purchase
• Single Family Home
• 740+ FICO Score
• 25%+ Down payment
• Conventional loan
• 21-30 day rate lock
• Typically at least 1 discount point to “buy” down the interest rate

If you are buying your home with less than 20% down and PMI is required for your loan, then the PMI you are projected to pay is added into your APR which inflates this number greatly above typically advertised APRs. 

If you are obtaining FHA or USDA financing, then you’ll have an upfront mortgage insurance premium payment in addition to monthly PMI, all factored into your APR. 

If you are buying your home with VA financing, then the upfront VA funding fee (if applicable) is factored into your APR. 

Unless you fit into a standard conventional loan with 20%+ down payment, the APR is not a very good tool in helping you select a lender as PMI can skew the APR in such a way as to mask the other lender fees and charges you may have to pay.

When reviewing what each lender has to offer you, look at the lender’s origination charges and/or discount points.  The origination fees can be up to 1% of your loan amount but usually just contain a fixed lender fee for originating the loan.  Sometimes this fee can be called the Administration Fee, Underwriting Fee, Processing Fee, and/or Lender Fee but all fall under origination charges on the Loan Estimate.  Most lenders charge about the same amount for “lender fees/origination charges” but it is how they price their discount points that mostly separates one lender from another.

Discount points are used to “buy” down your interest rate if it makes sense financially.  One discount point is 1% of your loan amount, so if you have a $400,000 loan, 1 discount point will cost you $4000 at closing. This will benefit you with a lower interest rate and monthly principal and interest payment for the life of the loan. 

If lender A quotes you 4% at a cost of 1 discount point and lender B is offering 4% with 0 discount points, then usually lender B is the best deal unless their origination charges are significantly higher than lender A.  For confirmation, look at the APR for each 4% option just to confirm there aren’t significant hidden/junk fees at lender B that make the overall costs higher than lender A.  If lender A has an APR of 4.17% and lender B has an APR of 4.12%, then clearly lender B is better without having to review the specific closing costs for each one.

All of that is not so clear cut once you introduce PMI, upfront mortgage insurance premiums for FHA and USDA loans, and/or VA funding fees for VA loans.  Some lenders don’t even properly disclose the required third party charges in their APRs, which can lead to inaccurate APRs in initial quotes, often not corrected until the rate is locked and an official Loan Estimate disclosed. 

As a home buyer, keep in mind that no matter which lender you select, the third party fees (appraisal, escrow, title, attorney, and etc) will be pretty much the same.  If you look at just the lender fees/origination charges and discount points associated with a quoted Note rate, it will become much clearer which lender is offering the better price over the other.