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Annual Percentage Rates (APR) In comparing any type of loan, whether it be a fixed rate loan to a fixed rate loan, adjustable rate loan to adjustable rate loan or fixed rate loan to adjustable rate loan, there is one way that can be used to compare apples to apples and even apples to oranges. APRs are designed to do just that. APRs are a way to calculate the annual cost of loans, taking into consideration loan origination fees (points) and the other costs associated with securing a loan. The additional costs include appraisal and credit report fees as well as processing and document fees. One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Regulation Z (Reg Z, the mortgage companies disclosure of cost for the loan) is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation. For our illustrations we will use only the points, appraisal, credit report, processing and document fees. As a means of protecting consumers from companies who did not disclose the fees associated with a particularly low start rate on an adjustable rate loan or below market rate on a fixed rate loan, APRs give consumers a way to check the true cost of a loan. Regulation Z One common situation that occurs when a borrower receives a Reg Z, and a copy of their note, is the column that indicates the amount financed is less than the loan amount the borrower is actually financing. It is here that many borrowers leap before they look and call to find out why they are only receiving a $146,925 loan when they applied for a $150,000 loan. It is here that APRs enter the picture. Let's look at how APRs are calculated. For our illustration we will assume a 8.50% fixed rate interest. For a 30 year loan the monthly payments for a $150,000 loan are $1,153.37. In order to calculate the APR for this loan we subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,0750 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $146,925 loan with the same payment of $1,153.37, the APR is calculated as 8.73%. How does this compare to a 30 year fixed rate loan with a 8.00% interest rate and 3.50 points? The monthly payments for this loan is $1,100.65. In order to calculate the APR for this loan we subtract $5,255.00 (3.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $6,075 = $143,925). The $143,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $143,925 loan with the payment of $1,100.65 the APR is calculated as 8.44%. Loan Decisions using APRs In choosing which loan is best for your needs, it is important to look at other factors in addition to the APR. If you don't plan on keeping the property or the loan for the full term, the calculation of actual costs needs to be adjusted, generally this will increase the APR calculation. Below is an example of how the APR differential increases based on holding the loan for a shorter period of time. ASSUMPTION - $250,000 LOAN and 30 YEAR TERM
Calculating APRs on adjustable rate loans (ARMs) is a much different set of calculations. For ARMs you need to take in to consideration not only the starting interest rate, but any adjustments that will occur until you reach the fully indexed rate. In calculating APRs on adjustable rate mortgages (ARMs) you need to take in to consideration not only the starting interest rate, but any adjustments that will occur until you reach the fully indexed rate. The fully indexed rate is determined by adding the index to the margin. Assuming an ARM with a start rate of 6.25% at 1.50 points with a margin of 2.75 over the 1-Year Treasury Security (6.39 index) with annual adjustments of 2%, the APR calculations for a $150,000 loan would be as follows. The first years payments would be $923.58. Factoring for principal reduction the following payment schedule would occur. Second year 8.25% interest, payment $1201.23. At this point the loan will reach the fully indexed rate of 9.25% interest, (Index value 6.39 + margin value 2.75 = 9.14 , rounded up to the nearest 1/8th percent or 9.25%) payment $1327.13. For determining the APR this payment and interest rate is assumed for the remainder of the 30 year term. There are a few ways in which you can solve for the APR in this case, first you could run a IRR (internal rate of return) calculation, time-consuming and complicated at best. You could design a spread sheet to do so, or you can take the sum of the payments and determine what the average payment would be for the 30 year term. In order to calculate the APR for this loan subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,075 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this mortgage. By solving for the interest rate for a $146,925 loan with the same payment of $1,233.58 the APR is calculated as 9.473%. Monthly Adjustables Calculating APRs for monthly adjustable rate mortgages is just a bit different. For a monthly ARM (one with potential negative amortization) you need to take into consideration only the starting interest rate, and one adjustment to the fully indexed rate. Assuming an ARM with a start rate of 4.50% at 1.50 points with a margin of 2.50 over the 11th District Cost of Funds (4.747 index) reaching it's fully indexed rate on the fourth month the APR calculation for the same $150,000 would be as follows. The first 3 months payments would be $760.03 At this point the loan is fully indexed at 7.247%, factoring for principle reduction the payment for the remainder of the term is $1,021.31. For determining the APR this payment is used for the remainder of the 30 year term. In order to calculate the APR for this loan subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,075 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this mortgage. By solving for the interest rate for a $146,925 loan with the same payment of $1,019.13 the APR is calculated as 7.41%. Based on just the APR comparison the second loan appears to cost less. Choosing which ARM loan is best for your needs with just APRs can be a mistake. With ARMs you also want to look at the life time cap, the history of the index and also the current trend of the index values you are comparing.
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