APR Simplified.
Whenever you apply for a loan, the lender has to provide you with a Good Faith Estimate (GFE) and a Truth In Lending (TIL) disclosure. The GFE is a list of all the different fees involved in processing your loan. It also list what funds you’ll need to advance for homeowners insurance, taxes, etc… but that’s a subject for another day.
Instead let’s discuss the TIL, more specifically, let’s discuss the APR. If you’ve financed a home before, maybe you remember this little box on the TIL. Maybe it didn’t make any sense, and maybe the Loan Officer did his best to gloss over it. The APR is the REAL, or effective cost of the loan. It takes into account all of those fees listed on the GFE and converts them into an adjustment to the interest rate.
Confused? Okay, let’s pretend I am 8 years old. I want to borrow $10 dollars from one of my brothers so I can buy the GI Joe with the Kung-Fu Grip. My 14 year old brother offers to lend me the 10 bucks, but I have to pay 5% interest. My 17 year old brother offers to lend me the money at 0% interest, but I have to pay an upfront $1 processing fee. The 17 year old’s deal sounds better at first because it’s zero interest, but if he had to provide a TIL, we’d see that his $1 fee raises the APR from 0% to 10%* Typical sneaky brother stuff.
APR is important, don’t let the Loan Officer tell you any different. If you want a more detailed explanation of how APR works on a full mortgage, read on.
Here’s an example of a30 year fixed rate loan:
Loan Amount $100,000
Number of Payments 360 (for a 30 year loan)
Monthly payment $804.62
Interest Rate 9%
Now, let’s say the lender charges you a 1% Origination Fee and $500.00 processing fee. To keep it simple, lets say those are the only fees you pay. 1% of $100,000 is $1000, plus $500 is $1500 dollars in fees. So, if you have to pay $1500 dollars up front to get a $100,000 loan, you really only got $98,500. Now apply the new loan amount to the original payments:
Loan Amount $98,500
Number of Payments 360
Monthly payment $804.62
Interest Rate 9.17% - This is your APR.
If all of this makes sense, you now know more about how APR works than about a third of all loan officers. Now that you see how important this number is when comparing loan offers, you’re better prepared to pick the best one.
* There’s more to the math, but I’m keeping it simple for the sake of explaining the concept.