11 May What is the Difference Between My Interest Rate and the APR?
When shopping for a mortgage loan, most consumers are concerned with the interest rate of the loan. Within the past five years, interest rates on mortgages have hit historical lows and many home loans have been made. But there is more to a mortgage loan than the interest rate and a careful shopper will look at all of the options. Some of these option will affect the monthly payment, but many are ‘got ya’s that can change the affordability of a loan overnight.
When advertising the availability of a loan, lenders are required by the Truth in Lender Act to disclose an Annual Percentage Rate (APR) which most consumers confuse with the interest rate on the loan. The confusion is legitimate, the A.P.R. is always disclosed as a percentage (%) and the lenders don’t want you to know the difference.
The real problem is that the projected A.P.R. may have nothing to do with the loan you actually get. A subsequent disclosure of the A.P.R. is required in final form only at the time the loan is made. This reflects the fact that interest rates and loan charges can change overnight drastically altering the terms of the deal.
Most people can figure out what the interest is on a loan. You take the principal amount of the loan and multiply by the interest rate. That answer on the most simplest level is the amount of interest earned in a year. To get your monthly interest, you have to divide that number by 12. So, in the case of an interest-only loan, that would be the amount due to be paid that month.
But if you want to ever pay that loan off, you know you have to pay more than that. That concept is called amortization. An amortization formula is much more complex and can take in the amount of days a month, since some have more than 30 and one has less. Never underestimate how clever your banker can be to figure out how to make money. But with mortgage loans, there’s more. We have all heard of points, commissions, closing costs and other fees. Those charges will affect the payments on your loan as much as the interest rate.
Congress recognized that fact as far back as 1979 and tried to deal with it. Obviously, if you are going to get charged those fees and you are not paying them up front, the lender will simply deduct them from your loan amount. This leaves you less than the full amount of the loan (the principal) to use to buy a house (or car, etc.).
If those charges are determined to be a cost involved with the making of your loan, the Truth in Lending law requires that they be calculated back into the A.P.R. So the A.P.R. is not the interest rate of the loan, but the interest rate of the loan and all of the associated bank costs in making the loan. If there is a large difference between the real interest rate on the loan and the A.P.R., you should know that the loan is very expensive.
Consider these examples:
Loan 1: $100,000 at 5% (simple interest no loan charges) for 30 years is a monthly payment of $536.83.
Loan 2: $100,000 at 5% (but with two points at $2,000 and $3,000.00 in additional loan charges) for 30 years is still $536.83, but you will only get $95,000 to spend at the time of the loan closing. The A.P.R. of that loan might be 5.5% (don’t hold me to exact calculation as it is very complex) showing that the .5% difference means you need to come up with another $5,000 at the time of the purchase.
Even though the monthly payment is the same on both loans, the A.P.R. shows that the second loan is actually more expensive because you get to use less of the money you are borrowing for the purpose which you intended. As with nearly everything Congress does, the concept of disclosure is great, but the execution is lacking. To make matters worse, a borrower does not get the final disclosures of the A.P.R. until the day the loan is made.