What is APR?

Rarely is there such a simple question in the mortgage industry with such a complicated answer. The true definition of this one even puzzles some seasoned veterans. The good news for you and for them is that there is a generally accepted brief version of the answer that even experts will use. The bad news is that, in order to truly understand, let alone be able to explain the calculation for APR, a truly long and complicated answer is the only option.

For those of you not interested in long and complicated, here is a very serviceable and very brief definition: APR is the true cost of money over time.

In other words, your mortgage has a NOTE rate, or the interest rate on your loan, but it also has closing costs, prepaid interest, and other finance charges. The APR is the cost of your normal interest and those finance charges over time expressed as an interest rate relative to the rate you are paying on your mortgage.

APR stands for Annual Percent Rate and was made a requirement of mortgage disclosures by the Federal Truth in Lending Act. It is intended to level the playing field among mortgage quotes. For instance, one loan might advertise a 4.5% NOTE rate, while another advertises 6.5% rate. But both of those loan's APRs could be exactly the same, meaning that although the 4.5% loan appears to be the better deal, if you take closing costs and finance charges into consideration, the cost is actually the same as the 6.5% loan. In fact, if you were to sell or refinance the house sooner rather than later, you'd probably pay less interest overall on the 6.5% loan!

Perhaps the most idiotic thing about APR is that the finance charges that contribute to the APR calculation must be manually checked and included by the person originating the loan. Because of this, two identical mortgage quotes could have completely different APRs because one of the loan originators didn't do their job correctly. Even worse for consumers is that the lower APR quote in this example would be the one generated by the inferior originator. My blanket advice is to know the NOTE rate of the loan you are applying for, and know the exact closing costs. Do not trust anyone's calculation of APR.

That said, I will now cover the details of the APR calculation.

Let's start with the definition that everyone is working from, found in US Code Title 15, Chapter 41, Subchapter I, Part A, 1606:

"that nominal annual percentage rate which will yield a sum equal to the amount of the finance charge when it is applied to the unpaid balances of the amount financed, calculated according to the actuarial method of allocating payments made on a debt between the amount financed and the amount of the finance charge, pursuant to which a payment is applied first to the accumulated finance charge and the balance is applied to the unpaid amount financed"

Now a caveat to further discussion: I do not profess to be an expert when it comes to deciphering this code. More scholarly mortgage professionals than I have attempted to understand and communicate APR and yet have failed. Attempts by those same people to apply APR formulas to mortgage data have also failed.

We will soon see that PREPAID FINANCE CHARGES are the only thing that makes APR different from INTEREST RATE as defined by our government. "Interest rate" specifies an interest return to an investor in the form of yield, whereas APR adds the impact of prepaid finance charges (fees required by the lender and/or originator from which a profit is derived), and expresses the result in the format of a rate. Let's dissect this:

1. "That nominal annual percentage rate" In this context, we'll see that nominal means "minimum." For the purposes of making this definition easier to understand, we can simply call it: "The Rate"
2. "which will yield" The second clue here is the word "yield." In this context, the yield is the amount of return an investor will receive on a "debt instrument," in this case a mortgage loan. This phrase could be re-written as: "that would be high enough to earn."
3. "a sum equal to" Translation: "the same"
4. "the amount of the finance charge" Ah! Now we're getting tricky! This is not as simple as it looks! Not only are finance charges all the applicable fees required by the lender (most closing costs), but finance charge is also any interest paid in advance or throughout the life of the loan. Thus "finance charge" is this context is the total profit that this loan is scheduled to earn assuming constant yield amortization (which we will discuss shortly). So this action packed little gem could be rewritten as: "profit generated by fees and interest of this loan"
5. "when it is applied to" Go back to the definition and read carefully, or you'll get lost for 3 years as I did. The "it" in this sentence refers to the subject of the sentence which was the "rate." Translation: "had that rate simply been applied to"
6. "the unpaid balances of the amount financed" Simply put, this is what you and I know as: "the principal"
7. Finally, we can take the previous two sections "had that rate simply been applied to the principal" and translate them into the following: "without fees"

So here is (what I hope is), a more understandable and accurate definition of APR based on my translation:

"A rate that would be high enough to earn the same profit generated by the fees and interest of this loan, without fees."

In other words, the loan you are about to get will generate profit. Of course your loan has an interest rate, and the interest is profit. This is inherent in the definition of an interest rate. What is not inherent is the presence of fees. The APR then simply adjusts the interest rate upward so that if it were applied to your loan with no fees, the profit would equal the exact same amount as the actual interest rate will PLUS the fees you pay upfront.

The final piece we haven't addressed yet: "calculated according to the...."

Thankfully, this is fairly simple. It refers to the Constant Yield Method as opposed to the Simple Interest Method of calculating the principal and interest allocation of payments. Basically, under the actuarial (or Constant Yield) method, you pay principal according to a predetermined amortization schedule. Even if you pay more than your current payment, it will not affect the amount of interest you owe for this month. Your interest and principal allocation will be based on where you were in the schedule, and you must pay all the interest scheduled for the month, even if you have just lowered your principal balance.

Basically, the authors of this definition had to specify an amortization method otherwise the definition would be open to interpretation, and applying a different method would yield different results.

The final word is that, although there is a high degree of human error inherent, APR attempts to express the interest rate of your loan accounting for the fees you will pay up front. This ostensibly allows you to compare apples to apples, and to be less susceptible to deceptive lending practices.

APR also exists to confuse and annoy most loan officers when they are asked for a more detailed explanation. I know this is a complicated topic. If you see a part of this that could be explained better, or if I have made an error (which is a fair possibility assuming the scope of this answer), please contact me so I can update this article.

APR is a federally engineered term that is very confusing to most customers. Simply put, APR is an equation that shows the true cost of a mortgage including costs associated with the loan itself.

If you notice on loan documents, when an interest rate is quoted, it will show APR usually below. In fact, it is mandated it be shown.

For example, if a bank offers you a loan with a good interest rate and low fees, the APR will be somewhat close to the actual interest rate on the loan. If another bank offers you the same interest rate, but heightens the cost due to inflated fees or points, the APR will reflect higher.

This allows you to compare "apples to apples" on similar loan products.