Why is the APR so much higher than the rate?
The APR is a mathematical calculation of the cost of financing . . . basically, the interest, the prepaid charges, the mortgage insurance, etc. . . . all the things that you pay as a borrower that someone who had their own cash for the transaction would not.
Some items that can cause your APR to be higher than your mortgage:
The lender imposed costs of closing (many of which are fixed no matter what size the mortgage is, so they will have a larger proportional effect on the apr on a small loan as compared to a larger one),
Paying " points" - either as broker fees, or in many cases, to obtain a lower rate
"Prepaid" interest . . .the typical daily interest that is paid until the end of the current month
Mortgage insurance, both "upfront"/"single premium" and monthly (which is considered a part of the cost of the transaction, but is not a part of the interest rate)
Generally certain costs of a mortgage transaction (such as recording fees, something that a cash buyer would ALSO pay) are not included. Feel free to ask your lender for a detailed breakdown of the prepaid finance charges that are affecting your apr. If comparing aprs in order to ascertain which option makes more sense for you, make certain that both lenders are calculating the figure in the same way, for the same length of time, and proposing to close at the same point in the monthly cycle in order to make an accurate comparison.
The APR can be higher than the nominal interest rate of a loan for a variety of reasons. To understand why though, it is helpful to first understand what is APR and how it is calculated.
APR, otherwise known as the Annual Percentage Rate, is the corresponding percentage rate reflecting the cost of financing. Its purpose is to provide a single measure to help consumers compare mortgage terms. It is disclosed on the Truth-In-Lending Disclosure Statement which describes APR as "the cost of your credit as a yearly rate".
For purposes of the APR calculation, items defined as prepaid finance charges are deducted from the loan amount. The Annual Percentage Rate is calculated by amotizing this reduced amount over the course of the loan's amortization period. The rationale behind this is that you are not getting the full benefit of the whole loan amount since you are being charged costs to obtain that financing.
It is important to note that not all closing costs are treated as Prepaid Finance Charges so the APR is not a true reflection of all of the costs for obtaining a home loan. In addition, the rules that govern what is treated as a PFC under the Federal Truth-In-Lending Act (Regulation Z) are complex and subject to interpretation such that not all lenders treat the same items as a Prepaid Finance Charge. This in turn can lead to discrepancies when comparing APRs among lenders.
Items typically treated as Prepaid Finance Charges are :
Escrow Waiver Fee
Lender Inspection Fee
Loan Origination/Discount Fee("points")
Mortgage Broker Fee
Tax Service Fee
Items NOT treated as Prepaid Finance Charges are :
Doc Prep Fee
Points Paid by Seller
Well and Septic Inspection