What is the Purpose of APR?

By Stevie Duffin Updated on 7/19/2017

The majority of borrowers may have heard the acronym APR, but many don't understand it or the factors that contribute to its calculation. 

This article will explain the purpose of APR, how APR functions, the fees used to calculate APR, as well as the limitations of APR.

What is APR?

Annual percentage rate is a percentage which represents a realistic assessment of yearly costs associated with a loan. In addition to mortgage rates, annual percentage rate considers any fees or additional costs involved in a loan transaction.

In short, APR functions as an accurate calculation of yearly costs, instead relying solely on the note rate, or the rate used to calculate monthly payments.

The Function of APR

Regarding the interest-rate arrangement, transaction charges, late penalties, and a variety of other factors, it can be hard for a borrower to compare loan options to determine which offer best fits their unique circumstances. 

Annual percentage rate, however, provides borrowers with a basis for comparison, as all loan offers must include the calculated annual percentage rate.

For example, imagine that you have been offered two similar loans from different banks; Bank A offers a 30-year fixed-rate mortgage with an interest rate of 7.00%, while Bank B offers a 30-year fixed-rate mortgage with an interest rate of 8.00%. At face value, the offer from Bank A seems better, but other factors must be considered.

To complicate matters, Bank A has included 7 points and an origination fee, as well as requirement of mortgage insurance. On the other hand, Bank Bs offer does not require mortgage insurance and does not include either an origination fee or additional points. 

On the basis of interest rates, Bank As offer appears as the clear winner; however, with all things considered, Bank Bs offer is cheaper. With the employment of APR, the assessment is made simple.

APR Limitations

Due to the various charges included in APR, such as private mortgage insurance, processing fees, and discount points, borrowers should carefully evaluate the fees involved in the calculation of their APR offers. Also, some fees may not be added within an APR quote, and consequently borrowers can be misled when choosing a mortgage offer.

Fees Used to Calculate APR

APR takes into account various fees associated with mortgage loan acquisition, the most common being:

• Origination fees
• Points
• Buydown funds from the buyer
• Prepaid mortgage interest
• Mortgage insurance premiums
• Lender fees (charges for application, underwriting, tax service, etc.)

Other fees, including title insurance, appraisal charges, and credit check fees, do not factor into APR calculation. Essentially, this is because these charges are not levied by the lender, and may not be considered for every mortgage transaction.

While APR provides a more reliable method of loan comparison, borrowers should carefully assess each of the fees included in this calculation. Don't rely entirely on this representation, but rather use annual percentage rate estimates as a starting point to build on.