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How Mortgages Work

Understanding APR

Probably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it's hard to compare apples to apples when comparing mortgages. Sometimes it seems like we're comparing apples to grapefruits.

For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there's a way to do that. Lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars.

The annual percentage rate (APR) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate -- hence the name. The APR will be slightly higher than the interest rate the lender is charging because it includes all (or most) of the other fees that the loan carries with it, such as the origination fee, points and PMI premiums.

Here's an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn't. Fortunately, the APR considers all of the fine print.

Say you need to borrow $100,000. With either lender, that means that your monthly payment is $665.30. If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 - $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $665.30 for a loan of $97,975. In this case, it's really 7.2 percent.

So the second lender is the better deal, right? Not so fast. Keep reading to learn about the relation between APR and origination fees.