APRs are designed to compare one loan to another. APRs are a way to calculate the annual cost of loans, taking into consideration loan origination fees (points) and other costs associated with getting a loan.
One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Regulation Z (Reg Z, the mortgage companies disclosure of cost for the loan) is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation. For the following illustrations only points, appraisal, credit report, processing and document fees will be used.
APRs give consumers a way to check the true cost of a loan.
One situation that tends to occur when a borrower receives a Reg Z, and a copy of their note, is the column that indicates the amount financed is less than the loan amount the borrower is actually financing. Many borrowers then hastily call to find out why they are only receiving a $146,925 loan when they applied for a $150,000 loan. This is where APRs enter the picture.
Here is how APRs are calculated. For this example let’s assume a 8.50% fixed rate interest. For a 30 year loan the monthly payments for a $150,000 loan are $1,153.37.
In order to calculate the APR for this loan we subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,750 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $146,925 loan with the same payment of $1,153.37, the APR is calculated as 8.73%.
How does this compare to a 30 year fixed rate loan with an 8.00% interest rate and 3.50 points? The monthly payments for this loan is $1,100.65.
In order to calculate the APR for this loan we subtract $5,255.00 (3.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $6,075 = $143,925). The $143,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $143,925 loan with the payment of $1,100.65 the APR is calculated as 8.44%.
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