Loan Tips - Calculating APR

We are often asked how the annual percentage rate (APR) that appears on the Truth-in-Lending disclosure is calculated. Here's how it's done:

1) In order to calculate the APR, we need to know the principal amount of the loan (the amount the buyer borrows from the lender), the interest rate, the term of the loan, and the closing costs. Let's assume the loan amount is $200,000, the interest rate is 6.5%, the term is 30 years, and the closing costs are $6,000.

2) First, the monthly payment is calculated by amortizing the $200,000 over 30 years at 6.5% interest. That gives us a payment of $1,264.

3) Next, we subtract the closing costs from the loan principal. However, we only subtract those closing costs that are related to the loan, not the costs that are related to the real estate side of the transaction. A good example of a closing cost that is related to the loan is the origination fee. An example of a fee that is related to the real estate transaction is the appraisal because even if the buyer paid cash for the house, they would still want to see an appraisal. Let's assume that out of the $6,000 in total closing costs, $4,000 of those costs are related to the loan. So, we subtract that $4,000 from the loan principal ($200,000), leaving us $196,000.

4) The final step is calculating what the interest rate would have to be for a loan of $196,000 in order to give us the same payment of $1,264. That interest rate is 6.695%. That is the APR.

The purpose of the APR is for the borrower to compare loans between different mortgage brokers. If each mortgage broker has the same loan amount, same interest rate, and same term, then whoever has the lowest APR has the best deal because they have the lowest closing costs.