What is APR and Why Is It So Important?
The most common question I get asked is probably: “What is the APR and what does it mean?”
The annual percentage rate, otherwise known as APR, is a calculation that is required to be quoted to you any time you are given an interest rate on a mortgage. This is enforced by the Consumer Financial Protection Bureau which was created in response to the financial crisis of 2008. It is very important to understand how APR works because while a lender may give you a competitive rate on your mortgage, the fees they charge may be different.
APR is calculated by taking both the interest rate on the loan and any closing costs that are considered finance fees and adding them together. Finance fees can be anything that is included in the closing costs such as underwriting fees, processing fees, administration fees, discount points, etc. and sometimes they are also specific to the loan product. Understanding the differences between loan products will help you understand what kind of APR to expect.
Examples Are Fun
At the time of this article the average mortgage interest rates and their corresponding APR rates are as follows:
Product Interest Rate APR
30-Year Fixed-Rate 3.24% 3.39%
30-Year Fixed-Rate VA 2.78% 2.95%
30-Year Fixed-Rate FHA 2.75% 3.62%
30-Year Fixed-Rate Jumbo 3.24% 3.34%
The time of these rates is irrelevant, but what I really want you to look at is the relationship between these rates.
Let’s take a deeper look at the first product, the 30-Year Fixed-Rate Conventional loan. The rate is 3.24% and the APR is 3.39%, a difference of only 0.15%. This is saying that above and beyond the interest rate, also called the note rate, there is 0.15% in fees you are paying for this loan product. This fee is often referred to as the “cost of credit”. This makes sense for a Conventional loan because there are typically fewer fees associated with a Conventional loan compared to other loan types.
Now, let’s take a look at the 30-Year Fixed-Rate VA product. Between the note rate of 2.78% and the APR of 2.95%, there is a 0.17% difference. You can see that the difference is greater for a VA loan compared to a Conventional loan and it’s because the VA loan is a government loan backed by the Department of Veteran Affairs and has some unique fees associated with that. The first is an origination fee, typically 1% of the loan amount, and the other is the funding fee, which is somewhere between 2.3% and 3.6% of the loan amount. The amount varies for the funding fee because the percentage used is dependent on whether this is your first or subsequent use of the VA loan. These fees, when added to the usual fees, associated with closing is why the APR will generally be higher for a VA loan compared with a Conventional loan of the same interest rate.
Lastly, we move on to the 30-Year Fixed Rate FHA product. The interest rate is 2.75% with a corresponding APR rate of 3.62% has a difference of 0.87%. You’ll note the fees here are the highest of the 3 loan types we’ve looked at. This is because the Federal Housing Administration loan, otherwise known as FHA, is also a government program and charges some mandatory fees. There is an Upfront Mortgage Insurance Premium (UFMIP) of 1.75% as well as an Annual Mortgage Insurance Premium (MIP). At the time of this article a typical FHA MIP is 0.85%. The UFMIP is a one-time charge whereas the MIP is a monthly charge that gets added to the mortgage payment. You can calculate the MIP on your loan as 0.85%, or 0.0085, multiplied by your loan amount and divide by 12 to get your monthly payment.
For example, if you had a loan amount of $200,000:
200,000 x 0.0085 = 1700
1700/ 12 = 141.67
According to this calculation, you can expect to pay about $141 a month in MIP on this FHA loan.
As you can see as a general rule FHA loans are going to have higher fees associated with them compared to a VA or Conventional loan, and conventional loans generally have the least amount of fees.
I hope now that you understand a little more about what the APR is and how it relates to your interest rate. Now you can be confident in making an informed decision when selecting a mortgage product as well as a mortgage lender.
