How to Understand and Calculate the APR on a Mortgage Loan

APR or, (Annual Percentage Rate), is a mystery to many and can be confusing when seen on the Truth In Lending mortgage document, since the APR is higher than the quoted interest rate, when closing costs are rolled into the loan and financed.

So what is the purpose of APR? How is it calculated? Is there a way to avoid it?

These are important questions if you are a Loan Officer or a borrower, which I hope to answer for you.

It is really quite a simple concept and nothing more than a calculation that was devised by the government so that a borrower would know what the "true cost" of their loan is when also financing the closing costs.

Things You'll Need

• Financial calculator that can calculate mortgage payments based on term, interest rate and loan amount.

Instructions

1. Lets use $100,000. as our final loan amount, which includes all closing costs, such as points, lender fees, underwriting charges and any other costs related to the mortgage loan.
   Use 7.000 for a fixed interest rate over a 30 year repayment term.
   The monthly payment is $665.30
   Now lets assume that the closing costs rolled into the loan and being financed are $5,000. This means the actual loan amount the borrower will receive is $95,000.

2. To determine the APR, input $95,000 as the loan amount, the "actual" loan amount the borrower will receive, the same 30 year term and the monthly payment of $665.30
   The unknown factor here that we want to discover is what the APR will be? The answer is 7.520

3. This is where many people get confused. OK, so the rate quoted is 7.000 but the APR is 7.520 "Why the difference"?
   The simple logic is that based on 100,000, the payment of $665.30 checks out at 7.000 on a 30 year term, but based on $95,000, using the same monthly payment of $665.30, and the same 30 year term, the APR is 7.520
   See, by using the same monthly payment of $665.30 but based on a lower loan amount, $95,000 instead of $100,000 the rate or APR would naturally be higher.

4. The true interest rate is still 7.000. Remember when you figured out the payment for $100,000 at 7.000 for 30 years. It was $665.30 and is still $665.30 no matter how many more times you calculate it.
   The APR calculation is just a way to separate the actual loan amount of $95,000 from the total loan amount of $100,000, which includes the $5,000 closing costs.

5. To go a step further and understand how to avoid APR all together, lets look at APR from another standpoint.
   If the borrower were to pay all closing costs out of pocket and not roll them into the loan, or if there were zero closing costs, the final loan amount would only be $95,000 and not $100,000, and if you calculate the monthly payment based on the $95,000 final loan amount, at 7.000 interest over a 30 year term, the monthly payment would only be $632.04

6. Hopefully you now see the difference between APR and actual interest rate, and understand the purpose of it. Use other loan amounts and closing costs examples for a practice!

Tips & Warnings

• Remember that the APR is only a calculation to show the true cost of the total loan amount when closing costs are rolled into the loan. The actual interest rate for the final loan amount does not change to the higher APR rate.

• If a borrower were to pay all fees and costs related to the loan out of pocket or if there were zero closing costs, there would be NO APR.