APR: What Every Home Buyer Should Know
Brent Hecht is a CPA and the founder of IQCalculators.com which provides a ton of free, easy to use financial calculators to help empower consumers in their important financial decisions. We are big fans of his work and use his calculators regularly to work through the numbers on our investments.
APR stands for Annual Percentage Rate and it may be the most important number to pay attention to next time you buy a house. In fact, lenders are required to disclose the APR to borrowers by the Truth In Lending Act...that’s how important it is. That’s because lenders will sometimes only talk to their clients about the interest rate and turn around and charge large fees on the front end to make up for the low interest rate. Most lenders operate fully above board and wouldn’t do this, but the APR is required so that consumers can protect themselves when they do.
The APR also creates opportunity for comparison and competition between lenders. Here’s an example. Let’s say one lender is offering a loan with an interest rate of 4% and charging fees of $1,000 up front. Another lender is offering a 3.75% interest rate loan but is charging $2,000 up front. How do you know which is the better rate? This is where the APR comes in to help you decide by making an apples-to-apples comparison between the two loans. If you're really good at math you can calculate the APR yourself, or use an APR calculator to get these numbers. Luckily there's no need for all of that, as your lender can and should provide you with the APR—they're required to by law, after all.
Here's where we see what APR is really made of. APR is calculated by considering all fees and using the interest rate compounding method to calculate an actual or effective interest rate. As in our example above, lenders can dress up their loans all sorts of different ways to seem more attractive than their competitors. But the APR takes all charges into consideration to level the playing field. So what are some common charges you might see comprising the APR from your lender?
Loan Origination Fees
Loan Processing Fees
Fees For Reviewing Appraisal
These are the primary fees that your lender has control of. There are other fees they don't control, but those should be standard across lending institutions.
Now that we have a good foundational understanding of APR, let's look at some APR details that will really empower you as the borrower. Most people don't realize that the APR you're provided is the APR as calculated in the last year of the loan. In other words, it's the APR as if the loan is held and paid off in the last year when the loan amortization ends. Why does this matter? Does APR change if the loan is only held until year 10 on a 30 year mortgage? The answer—depending on how the loan fees are structured—is most likely yes. This is important because most people only stay in their homes for 7 to 9 years before moving on. If this is the case, it makes sense to know the APR in year 7 to 9 more than to know the APR in year 30. You can either ask your lender to provide you with the APR in your projected time horizon or you can do it yourself using an APR calculator.
A quick recap on why APR matters to you when you get a loan for a new home: First, it is the metric by which different loan offers can be measured. Second, it is the calculated interest rate that factors in all costs associated with the loan...which is what makes it useful for comparison. Third, it's important to know the APR in the early years of the loan as most people don’t own the same home for longer than 10 years.
When you know the APR and how to use it, you become a better borrower, getting the most for your money with the least stress in the huge undertaking that is buying a home. Good luck!
Brent Hecht —IQCalculators.com