The Annual Percentage Rate, or APR, is often the most misunderstood number consumers see when applying for a mortgage.

Even though consumers are provided mounds of documentation explaining various processes, closing costs and cash-to-close requirements, it seems the APR is the number that causes more head-scratching than others. Too often, even the individual loan officer can’t explain the APR without getting confused or worse, telling the applicant that it’s not really that important and to ignore it. The note rate is used to calculate monthly payments, not the APR.

The explanation is this: The APR represents the cost of money borrowed expressed as an annual rate. That’s it. It’s that simple.

How is it calculated?

It’s a combination of the note rate, the rate used to calculate a monthly principal and interest payment with a nod toward certain closing costs needed to get a particular rate. Lender fees and other third party services may also be needed, and they all need to be paid for at the settlement table, referred to as finance charges. But upon an initial application where disclosures are required by statute to be prepared and delivered to a borrower, the APR must be disclosed at the same time.

APRs are supposed to provide consumers with the ability to shop around for rates and compare one lender to another. The thinking is if one lender has a lower APR than another, then the lender with the lower APR is offering the best deal. But that’s not really the case. APRs can vary based upon the term of the loan, closing costs and which day the APR was initially prepared. An APR for a 15 year loan will be different than the APR for a 30 year loan even with the exact same loan amount. APRs are good consumer tools, but only if properly used.

The key is the difference between the note rate and the APR. If there is somewhat of a large disparity between the two, that tells you there are more fees involved. An APR where the difference between the note rate and APR is relatively minor, tells the borrower there are fewer prepaid finance charges needed to get the desired rate.

Here’s an Example

A borrower gets a note rate of 3.25 percent and the APR is disclosed at 3.27 percent. Now, the borrower gets a note rate quoted at 3.25 percent and the APR is 3.50 percent. This is all for the exact same loan term and loan amount, remember. The loan with the 3.27 percent has fewer finance charges needed compared to the 3.50 percent number. Lower finance charges provide a lower APR number.

When you receive your loan disclosures, review your documents carefully and look for the APR number in the file. It will be there. If you have any questions about the APR, simply call me and we’ll review together. But put simply, the APR represents the cost of money borrowed expressed as an annual rate.

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