What Is APR and How Does It Work?
What is APR aka Annual Percentage Rate?
APR is a term that you’ve probably come across while viewing credit card details or even obtaining a home or car loan. As an acronym, it stands for Annual Percentage Rate, but what exactly does that mean?
The Meaning Behind APR
APR was designed to help people compare different loan programs and lenders. Many people’s first instinct is to compare businesses based on the interest rate, but that is not as representative of the actual cost of borrowing as the APR is. This is because the APR calculates the additional fees and amortizes them across the lifetime of the loan (this means that it evenly spreads these fees out instead of keeping it in one lump sum, which is how these fees are normally paid).
Assuming that the loan will be paid off after the full loan term (not earlier or later), the APR takes that number along with the interest rate and presents them as a single percentage of the loan amount. This is useful to determine how much it may cost you to borrow that money over the lifetime of the loan.
While APR is commonly used to make comparing different products and lenders easier for the borrower, it is not one-size-fits-all. There are certain fees that may be excluded from the APR which could lead you into thinking you’re picking the most affordable option when that may not be the case.
We highly suggest reviewing the actual interest rate and itemized breakdown of the loan costs before moving forward with a loan. Being proactive in such a detailed process will help you avoid unspoken surprises and other common mortgage mistakes.
How Do You Calculate APR on Adjustable-Rate Mortgages (ARM)?
The loan type also has an effect on the APR and how it is calculated. For fixed-rate loans, it is fairly straightforward since the rate stays the same throughout the lifetime of the loan (granted that the loan is not refinanced). Variable-rate or adjustable-rate mortgages (ARM) are where it gets a little trickier to calculate because the rate can change over the course of the loan. Adjustable-rate mortgages tend to have an initial fixed-rate period which can change once that period has ended.
For example, a 7/1 ARM is fixed for the first 7 years and then may adjust every year afterward, and a 5/1 ARM is fixed for the first 5 years and can adjust every 1 year after that.
The APR on ARM loans is calculated based on the initial interest rate and how it relates to the index interest rate. The index interest rate is what the future rate can be once the initial fixed-rate term has expired combined with the benchmark interest rate (“LIBOR” is the most commonly used). The benchmark interest rate is what lenders use to reflect general market rates for borrowing.
In order to calculate the APR for an Adjustable-Rate Mortgage, multiple payment streams are taken into consideration to make a blended rate APR. One payment stream will be based on the initial interest rate term, another will be based on the first initial increase (if there is one), and then the following payment streams will reflect each adjustment period until it reaches ceiling rate, or the lifetime rate cap. Once the payment streams are determined and the closing costs are added, APR is then calculated.
For example, if the initial rate is 3.75% for a 5/1 ARM loan starting off with an initial rate adjustment cap of 2% per year and lifetime cap of 5%, the payment streams would look something like:
Payment Stream A at 3.75% for 60 payments (five years).
Payment Stream B at 5.75% for 12 payments (1 year).
Payment Stream C at 7.75% for 12 payments (1 year).
Payment Stream D at 8.75% for the remaining 8 to 30 years.
These payment streams would then be used to calculate the APR. Keep in mind that these calculations are often worst case scenarios and they may differ from your actual future rate adjustments — if rates stay the same or go down you may highly benefit.
Which Fees Are Included in APR?
APR — Know Exactly What You’re Paying
Now that you know what APR is and how it’s calculated, you can use it to find the best lender to finance your mortgage. Good luck home shopping and reach out to us if you need any assistance along your journey!
Financing details are for educational purposes only. Rates, program terms, fees, and conditions referenced are subject to change without notice. Not all products are available in all states for all amounts. All mortgage applications are subject to underwriting guidelines and approval. This is not an offer of credit or a commitment to lend. Residential Wholesale Mortgage, Inc. dba RWM Home Loans is an equal housing lender licensed by the CA Department of Real Estate #01174642 and CA Department of Financial Protection and Innovation under the California Residential Mortgage Lending Act. NMLS# 79445
