This is a guest post written by Paul Braker who is a Residential Mortgage Broker working for The Mortgage Marketplace in Mt. Prospect. Paul originates mortgages throughout the greater Chicago area and even provides his home buyers with rebates. Imagine that!
The APR (Annual Percentage Rate) reflects the mortgage interest rate, any points, mortgage broker fees, and other charges that you pay to get the loan as a percentage of the loan amount spread out over the life of the loan. Because of this the APR will always be larger than the stated interest rate on the mortgage. It’s important to know that APR does not reflect all the cash required to close, not even close. It only tells you what the lender is charging you to secure financing for your loan. Third party costs and escrows are not considered factors in determining APR.
Unfortunately, there is even debate about what lender fees should and shouldn’t be included. As a result not all lenders use the same fees to calculate APR. What you see is very rarely what you get when lenders advertise APR. In this post we’ll explore the limitations of APR and how you can use it to shop for a mortgage.
The upfront fees charged by your lender are usually the biggest cost of your loan. Depending on the lender they may be more or less itemized but they typically include application fees, origination fees, underwriting fees, processing fees, verification fees, and rate-lock fees. It’s the total that matters but this total gets obscured in the calculation of APR as we’ll discuss below.
Sometimes lenders will express their fees as a percentage of the loan amount. Typically you will find that lenders will charge a 0.50% - 1% origination fee. On top of that fee you will also get charged a few other fees but these vary widely between lenders. The 0.50 -1% loan origination fee will almost always be the largest fee unless you pay for points to reduce your mortgage rate. Expressing charges as a percentage is smart for the lender because they move in direct proportion to the loan amount. What this means is that the APR will not change as the loan amount rises but you can bet the kids college fund that your costs will.
For example, consider a lender that charges a 1% origination fee. A $200,000 and a $400,000 loan with same rate will have identical APRs but the $200,000 loan will have $2000 in fees while the $400,000 loan with have $4000 in fees. Why an origination fee is more for a larger loan is a mystery. They’re doing the same amount of work to process the loan.
The size of the loan also has a significant impact on APR. So when you see an APR advertised you need to know what loan amount it’s based on. If you compare a $200,000 30 year fixed conventional loan at 4% with $5000 in lender fees to a $400,000 loan with the same terms and closing costs the $200,000 loan will have an APR of 4.206% while the $400,000 loan will have an APR of 4.103%. Lenders will often use larger loans in their APR illustrations because the percentage is drastically reduced when you spread fees over a larger amount. As a result the APR looks lower.
There is debate in the mortgage industry as to what should and shouldn’t be included in an APR calculation and regulators in the US seem to have trouble with defining this clearly. Because of this it’s important to ask every lender you work with what they are including into their calculation and then use that information in one of the many APR calculators available online. There is a certain level of discretion lenders have in determining APR. It’s not to the point of thousands of dollars but it does make a difference, and it can certainly make one APR look better than another.
Perhaps the most fundamental issue with APR is that it is usually calculated with all the costs spread over the full term of the mortgage. However, people will refinance or move before the original term is up and then their effective APR ends up being higher than originally advertised. I don’t blame lenders for this; it’s simply another factor to consider.
In probably all cases an advertised APR is based on the perfect client. This client would probably have a FICO of 800 plus with no credit issues, put 20% down, and have an excellent debt to income ratio. It’s not an accurate reflection of what a lender or bank can actually do for you since every person is different. In writing this post I used a mortgage APR calculator. I encourage you to use a calculator like this when shopping for a home loan in order to compare APRs for your specific circumstances.
Getting A Loan Estimate
APR is useful when you understand how it’s being calculated but as you can see this is a complicated topic and APR can be an oversimplification. The best idea is to speak with a loan officer at several places and ask for a loan estimate so you can get an accurate idea of what you qualify for. When comparing Loan Estimates, make sure to compare the origination fees. The CFPB does do a good job of explaining how the consumer should consider origination fees in loan estimates.
According to the CFPB a lender is only allowed to charge you for pulling your credit to obtain a loan estimate . Unfortunately some lenders have found a loophole and require a deposit to move forward. This deposit would be used for closing costs assuming you decide to close your loan with them. If not this deposit is kept. So be careful who you shop with.
The cost of any home loan is much more than what is considered in APR cost. It may be more beneficial for a consumer to ask what’s your best rate and cash to close. Then look at what the origination fees are. You should be able to negotiate some of those charges. That part of closing has the most monetary discretion and will determine the cost of doing business with a particular lender.
There are also other closing costs, not part of origination, like third party, escrow, and even prepaid interest costs but they cannot be accurately determined until close to closing. When you get your loan estimates these fees will be overstated to protect the lender or broker. This is common because they cannot be determined until later in the process when the title company and attorneys get involved. Shop smart and ask questions, make sure you work with a lender or broker that understands your needs and where you may need help. Buying a home is a big deal so don’t let anyone push you into making a commitment until you are confident you understand what is happening.
Gary Lucido is the President of Lucid Realty, the Chicago area's full service real estate brokerage that offers home buyer rebates and discount commissions. If you want to keep up to date on the Chicago real estate market or get an insider's view of the seamy underbelly of the real estate industry you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.