Description: Get to know the basics of annual percentage rate and also its shortcomings.
The annual percentage rate or APR is a useful tool to compare home mortgage loans offered by various lenders. The Federal Truth in Lending Act (TILA) has made it mandatory for the lenders to disclose the annual percentage rate whenever they advertise a rate.
APR basics
The APR has been formulated to regulate the advertising of interest rates and demonstrate the actual cost of borrowing to the borrower. It is expressed as an annual percentage rate. The goal of APR is to stop lenders from concealing upfront fees and other costs at the back of affordable publicized interest rates.
One puzzling feature of the annual percentage rate is that the calculation depends on the loan repayment term and hence it can’t be used to make comparisons between loans with different terms (for instance, 30 years vs 15 years). Due to this reason, annual percentage rates must only be used to compare same types of loan products and not loan products that have dissimilar repayment terms related to their payments.
What are the limitations?
The APR does have a number of limitations, largely connected to the fact that APR calculations are quite complicated and the methods of calculation differ among lenders. This indicates that two lenders with similar information might still work out two different APRs. Lenders use some caution while choosing which fees to include in the calculation of an annual percentage rate. Hence, different numbers might be generated by different lenders.
Furthermore, this model is imperfect in that when a loan product has an adjustable rate and is attached with a market index, it is believed that the index would never vary for the calculation purposes. This is a wrong belief that can generate APR numbers that can’t be compared between various lending sources.
The APR wouldn’t also inform you about prepayment penalties, balloon payments or for how much time your rate is locked in.
Under the APR, the upfront fees are distributed throughout the term of a loan. Hence the comparison of this is only precise if you intend to maintain the mortgage for the whole loan term. As most borrowers don’t retain the mortgage for the entire term (they usually refinance or shift), the annual percentage rate might make some loans appear superficially better.
You can use this number as a common rule of thumb that can help you shop around for loans. However, you must not only rely on the annual percentage rate to select which loan is most suitable for your requirements.
