Home Equity Loan
Annual Percentage Rate
Annual Percentage Rate (APR) is an expression of the effective interest rate
that will be paid on a loan. It is different from the "note rate" (the
advertised interest rate) because it includes one-time fees in an attempt to
calculate a "total cost" of borrowing money.
In a simplified example, if you borrow $100 for one year at 5% simple interest
(meaning that you will owe $105 at the end of the year) and you pay the lender a
$5 origination fee, your total cost to borrow the money will be $10 ($5 for the
simple interest plus $5 for the origination fee) and your APR is a bit less than
10%.
APR is intended to make it easier to compare lenders. In the US, lenders are
required to disclose the APR before the loan (or credit application) is
finalized.
While there are several acceptable ways to calculate the exact APR, the general
process is:
1.
Total the included one-time costs and add them to the face amount on the loan
2.
Calculate a monthly payment for that amount at the loan's "note rate"
3.
Calculate what interest rate would have to be applied to just the face amount of
the loan in order to equal the calculated monthly payment in step 2.
APR's failings
Despite repeated attempts by regulators to establish usable and consistent standards, APR does not represent the total cost of borrowing nor does it really create a comparable standard. Nevertheless, it is considered a reasonable starting point for an ad-hoc comparison of lenders.
APR cannot represent the total cost of borrowing
Some classes of fees are deliberately not included in the calculation. Because
these fees are not included, some consumer advocates claim that the APR does not
represent the total cost of borrowing. Excluded fees may include:
(a)
routine one-time fees which are paid to someone other than the lender (such as a
real estate attorney's fee)
(b)
penalties such as late fees or service reinstatement fees without regard for the
size of the penalty or the likelihood that it will be imposed.
Lenders argue that the real estate attorney's fee is an example of a
pass-through cost, not a cost of the lending. In effect, they are arguing that
the attorney's fee is a separate transaction and not a cost of lending. This is
true if the attorneys fees are the same everywhere, or if the customer is free
to select which attorney is used. If the lender insists on using a specific
attorney however, then the cost should be looked at as a component of the total
cost of doing business with that lender. This area is made more complicated due
to the practice of the lender receiving money from the attorney and other agents
to be the one used by the lender. Because of this, the government has made all
lenders produce an affiliated business disclosure form, which shows the amount
paid by the lender to things like appraisal firms and attorneys.
Lenders argue that including late fees and other conditional charges would
require them to make assumptions about the consumer's behavior—assumptions which
would bias the resulting calculation and create more confusion than clarity.
Loan retention assumed to equal loan pay-back period
Another problem with the APR calculation is the assumption that an individual will keep a particular mortgage loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term. The usual pay-back periods are 30 and 15 years but how many people keep the same mortgage that long? Not many, because the odds someone will either refinance or move before the loan is paid off are very high. Computing the APR over the full loan term deflates the apparent cost of the loan, making it harder to decide if it truly makes sense to refinance an existing mortgage. An APR calculator should allow the user to enter a loan retention period or time-in-loan period to more fully gauge the cost of the up-front fixed closing costs.
APR cannot result in a comparable standard
Regulators have been unable to completely define which one-time fees must be
included and which excluded. This leaves the lender with some discretion to
determine which fees will be included (or not) in the calculation.
In the example of a mortgage, the following kinds of fees are:
Generally included:
|
Somtimes included:
|
Generally not included:
|
The discretion that is illustrated in the "sometimes included" column even in
the highly regulated home mortgage environment makes it difficult to simply
compare the APRs of two lenders. Note: US regulators generally require a lender
to use the same assumptions and definitions in their calculation of APR for each
of their products even though they cannot force consistency across lenders.
In addition to the difficulties of determining what fees to include or exclude,
APR is dependent on the time period for which the loan is calculated. That is,
the APR for one loan with a 30 year duration loan cannot be compared to the APR
for another loan with a 20 year loan duration. APR can be used to show the
relative impact of different payment schedules (such as balloon payments or
bi-weekly payments instead of straight monthly payments), but most standard APR
calculators have difficulty with those calculations.
Non-repeatability
Two lenders with identical information may still calculate different APRs. The calculations can be quite complex and are poorly understood even by most financial professionals. Most users depend on software packages to calculate APR and are therefore dependent on the assumptions in that particular software package. While differences between software packages will not result in large variations, there are several acceptable methods of calculating APR, each of which returns a slightly different result.
Other Countries
Note that the above description relates to the US. The UK also defines APR in regulations, although the definition is different