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Does the Annual Percentage Rate (APR) Matter?

What is an Annual Percentage Rate (APR)?

  • APR attempts to factor in upfront costs to deliver an actual “cost of financing,” which is typically higher than the interest rate on your mortgage
  • APR relies on human input and variables that can be manipulated to a certain extent. Thus, it’s an imperfect measurement.
  • A slightly lower APR from one lender may not necessarily be a better deal – although the intent is to compare and find the better deals

Some upfront costs associated with a mortgage are considered “prepaid finance charges” because they are only paid to obtain the mortgage and are NOT tied to a tangible service.

EXAMPLE: Homeowners insurance is a tangible product that could (and should!) be paid for regardless of the presence of a mortgage. Therefore, it’s NOT a prepaid finance charge. On the other hand, a loan processing fee is only something you’ll pay if you’re getting a loan and therefore IS a prepaid finance charge.

Prepaid Finance Charges- what are they?

Prepaid finance charges (or PFCs) are neither good nor bad. They are not scandalous or uncommon. A loan without them isn’t necessarily a better deal than a loan with lots of them. And even if you’re told you’re not paying PFCs, most of them will still need to be paid by someone. Typically, this involves the lender offering a higher interest rate and then paying the PFCs for you. In that example, you’ve financed the PFCs by paying higher interest over time. Again, that’s neither good nor bad–just a choice between paying more upfront or more over time.

PFCs are most notable because they determine a loan’s annual percentage rate (APR). Lenders are required by law to disclose APR. This concept is a good idea but not so simple in practice. Regulators figure out the requirements to level the playing field by forcing lenders to give consumers an idea of the true cost of financing.

Are all APR calculations done in the same way?

Indeed, quoting mortgage rates in terms of NOTE rates and upfront lender-related costs is fantastic and ideal. Unfortunately, regulators leave it up to lenders to do their own APR calculations. While most lenders do things the same way, others do things differently in order to quote a lower APR than their competitors. Some lenders are more conservative in what they define as a PFC because they want to avoid regulatory scrutiny. Those lenders may have higher APR quotes than others, even if every upfront cost is precisely the same.

The bottom line, APR is not necessarily apples to apples. It would be best if you didn’t blindly trust one lender’s APR over another. As tedious as it may be, the best way to compare quotes is to see the upfront cost assumptions line by line.

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