APR vs Effective Interest Rate- What is the Difference?

So what is the difference between a person's 'Effective' interest rate versus their 'Annual Percentage Rate', or APR?

Effective interest rate is simply the rate calculated against a loan balance, over a specific number of years, to determine a person's monthly payment on that loan. This is the rate that a borrower will see on their monthly mortgage statement as well.

Annual Percentage Rate (APR) is the calculated effective COST, as a percentage, of securing a loan, over the expected term of the loan. It takes into account not only the effective rate, but also things such as prepaid interest, underwriting, processing, closing fee to the title or escrow company, all overnight charges for mailing by the title company and lender, flood certificates, points, upfront mortgage insurance, etc. Essentially, most other services required when financing is involved. The APR is calculated by taking the sum of all associated APR costs and subtracting them from the desired loan amount, then applying the effective rates monthly payment against this lower 'Amount Financed' to come up with the APR.

For example, John Doe is borrowing $200,000 on the purchase of his new home at an effective interest rate of 5.25%. His monthly payment for a 30 year term on this fixed rate is $1,104.41. John also has the following charges associated with the purchase and funding of his new home.

Underwriting Fee-                                          $400
Loan Processing Fee-                                   $400
Initial Flood Determination Report-                  $18
Closing Fee to the Title Company-                  $250
Courier Fee charged by Title Company-           $25
Tax Service Fee -                                          $60
Wire Fee-                                                     $25
Prepaid interest for 30 days-                          $863
 

Total of these APR calculated fees-                $4,041

The resulting 'Amount Financed' is as follows:

Actual loan amount of $200,000 less APR calculated fees of $4.041 equals $195,959 to be shown on the final TIL for the 'Amount Financed'.

The APR is calculated by taking the monthly payment of $1,104.41 against the newly established 'Amount Financed', resulting in an APR of 5.433%.

So what can change the APR enough to cause the need for re-disclosure to the buyer? Many things.  For instance, if in the example above we assume that the closing took place on the last day of the month instead of the first, and no prepaid interest was paid, the APR would drop to 5.393%. Additionally, let's say that the interest rate market improved and the lender secured the same rate for the buyer WITHOUT the Origination Point. Now, the resulting APR is 5.303%.

These 2 simple changes have a net improvement to the APR of .130% and since the newly established tolerances only allow up to .125%, the lender would need to re-disclose to the borrower. Furthermore, the borrower must now be allowed 3 business days to review the new disclosures before the transaction can close.

What other things can change the APR?

• Change in closing date, resulting in addition or deduction of prepaid interest.
  
• Change in interest rate
  
• Change in loan term. For example, from a 30 year term to only 15 years
  
• Increase or decrease in fees
  
• The addition or deletion of mortgage insurance or Upfront Mortgage Insurance Premium on an FHA loan
  
• A borrower decides to 'float' his or her interest rate from the initial disclosure time. Rate either goes up or down upon the final 'locked in' rate.
  
• Credit scores change from initial application, resulting in better or worse interest rate.
  
• Loan amount increases or decreases
  
• Loan goes from fixed rate to ARM, or vice versa
  
• Loan switched from one lender to another, resulting in different fees

So how can you assure your buyers and sellers of a smooth and effective closing?

• Be sure that your lender effectively communicates these changes to your buyers.
  
• Try to avoid changes to closing dates.

• Encourage your buyers to 'lock in' their interest rate at least 10 days prior to close.
  
• Get a preliminary HUD Settlement Statement from the closer at least 10 days prior to close.
  
• Partner with experienced lenders and title/escrow companies
  
• Give enough time to your contract closing dates to accommodate changes.
  
• Encourage your buyers to complete a formal loan application as early as possible. Also ask them to forward requested loan documentation quickly.

The recent implementation of the HVCC (Home Value Code of Conduct) has resulted in the requirement of all lenders to utilize a national appraisal service when requesting appraisals on any Conforming loans (FHA/VA and Jumbo loans are excluded from this requirement). Lenders are no longer to communicate directly with appraisal companies, but only through the national appraisal service that has requested the appraisal. Once the appraisal is completed and sent back to the national appraisal service by the appraiser it is reviewed. Upon completion...and agreement of value....by the national appraisal service, the appraisal is finally forwarded to the lender. The impact of this policy is a delay in recieving appraisals by up to 10 days, as well as additional expense to the consumer.
 

Finally, remember that 'rush' closings can not close any sooner than 7 BUSINESS DAYS from the date that borrowers receive their initial loan disclosures from their lender. If a loan starts with one lender and is transferred to another the clock starts over. If the final APR on the closing Truth In Lending disclosure goes up or down by more than .125% the borrowers MUST receive new loan disclosures and another 3 BUSINESS days must lapse before the closing can take place.