Annual Percentage Rate (APR)
Definition of "Annual percentage rate (APR)"
Annual Percentage Rate (APR) is a measure of the cost of credit that must be reported by lenders under the Truth in Lending regulations.
The Annual Percentage Rate (APR) takes into account the interest rate and upfront charges paid by the borrower, whether expressed as a percent of the loan or in dollars. It is usually higher than the interest rate because of upfront charges so that dollars paid by the borrower upfront carry a heavier weight than dollars paid in later years. The Annual Percentage Rate (APR) can be fixed or variable. The fixed ones are guaranteed not to rise during the life of the loan, while the variable can be adjusted for the time value of money in real time.
In principle, the Annual Percentage Rate (APR) should include all charges that would not arise in an all-cash transaction. In fact, only charges paid to lenders and mortgage brokers are included, and not all of those. No charges paid to third parties are included. Need examples? Title insurance and other title-related charges, appraisal, credit report, and pest inspection fees. Incomplete fee coverage means that the Annual Percentage Rate (APR) understates the true credit cost. If the understatement was consistent, this would not be a major problem, but it is not consistent. Fees that are not included in the APR are sometimes paid by the lender, in exchange for a higher interest rate. The APR in such cases indirectly includes fees that are excluded when paid by the borrower. Mortgage shoppers should not use the Annual Percentage Rate (APR) to compare loans where they pay settlement costs with loans where the lender pays the settlement costs.
What is an APR on an ARM?
We’re not playing charades. On an Adjustable Rate Mortgage, the quoted interest rate holds only for a specified period. In calculating an APR, therefore, some assumption must be made about what happens to the rate at the end of the initial rate period.
The rule is that the initial rate is used for as long as it lasts, and the new rate or rates are those that would occur if the interest rate index used by the Adjustable Rate Mortgage (ARM) stays the same for the life of the loan. This is a 'no-change' or 'stable-rate' scenario. Under a stable-rate scenario, at the end of the initial rate period, the interest rate used in calculating the APR adjusts to equal the Fully Indexed Rate. The FIR is the value of the interest rate index at the time the ARM was written, plus a margin that is specified in the note. When the Fully Indexed Rate (FIR) is above the initial rate, as it was during most of the 1990s, the rate increases on a no-change scenario. The Annual Percentage Rate (APR) is above the initial rate, even if there are no lender fees. When the FIR is below the initial rate, as it was during the first three years of the new century, the rate decreases on a no-change scenario. If not offset by high upfront fees, this can produce an APR below the initial rate.
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