Annual Percentage Rate:
Loans
are generally decided on the rate of interest basis. A 5.75%
loan means if your loan is $100
this year , it will become $105.75 next year and so on. In case
of home loans another loan program is used and this is known
as Annual percentage rate, this not only shows the basic interest
rate but also shows up the effect of fees etc. charged by the
companies. It is this rate which is used to compare the rates
of different companies. As an example if the rate of interest
is 5.75% then APR for one company may be 6.1 % and some other
company may be 6.15 %. This will clearly show to the borrower
that taking loan from the second company is going to be dearer
even if the basic rate of interest is same. It is required by
Federal Truth in Lending Law of mortgage companies to disclose
APR at the time of advertising rates.
What does APR
include:
The costs that are included
for the calculation of APR generally are
1. Points . Point is
actually 1% of the loan value. Some companies give discount
points .Both these and the ones to be paid to get that %age
interest are included.
2. Pre paid Interest
. The emi starts from the 1st of next month but the interest
is paid for the days of the month after the date of signing
of the deal. Most of the companies add a 15% interest in the
calculation but anything between 1 to 30 days interest can be
added for the original calculations.
3. LoanProcessing fee
this is charged by the bank or the financial institution
4. Underwriting fee
5. Documentpreparation
fee
6. Private mortgage insurance
This list also
includes the following two fees sometimes:
1.loan
application fee , not all banks charge this
2. credit Life insurance (This insurance is done for the loan
to be paid off if the borrower
is no more. ) In general this is waived off if the down payment
is 20%.
For calculations
of APR the following fees are not included:
1. Appraisal fee
2. Notary fee
3. Attorney fee
4. Closing agents document
preparation fee
5. Credit report fee
6. Transfer taxes
7. Recording fee
8. Appraisal fee
9. Title fee
10. Escrow fee
How does it help:
The best way of studying
this is with an example.Say there are two banks offering the
same period loan as follows
This means even if the
rate of interest is lower in Bank B one has to pay more money
in start to get the loan. Now a careful calculation will have
to be done as to how much interest will be saved and what will
be the overall effect. And supposing the house is left after
taking another loan for another
home after some years how much will be the saving in interest.
This is not a hypothetical condition. In actual 90 % of the
borrowers in USA buy another home or refinance their mortgage
in 2 5 years.
Obviously all these are
complicated and confusing calculations. To remove this confusion
the concept of APR helps. At a glance the borrower can know
what are the initial payments of a particular bank and where
he stands in the overall payment term. In the above example
the APR of A maybe 6.25 % and that of B may come to 6.72%. Now
there is no confusion.
How sound is
this Figure:
Though APR does give
an overall idea about the condition of loan to the borrower
but there are some places where this in itself is not enough
and the borrower has to ask the lender company for a detailed
estimate of all the costs he will have to bear from start to
the end. Some of these points are highlighted below :
1. APR is confusing as
it includes only a few and not every one of the lender fee or
the insurance premium as is clear from the lists given above.
It differs from lender to lender and from loan to loan.
2. The points payment
for a 15 year loan will be averaged
for 15 but if the loan is a 30 Year loan then it will be averaged
for 30. Naturally the APR will be lower in case of a 30 year
loan keeping every thing else as
same.
3. The interest rates
normally vary as per the index rate which is not constant ,
it is natural that the basis for all payments depending on this
are also changing. This makes the APR quite confusing sometimes.
4. APR does not indicate
about balloon payments or prepayment penalties or other points
as to the rate of interest change. The rate may be fixed for
some years and then will change. This can not be reflected in
the calculation of APRs.
APR Formula:
Section 226.22(a) of
Regulation Z provides the necessary basics for the calculation
of APR in the US.
The formula is a complicated
one and in general computer calculating sites are available
to give the values directly.
where:
S is the balance of cash
flows (almost always zero since the lender will insist on being
fully repaid)
• k is the current
cash flow
• N is the total
number of cash flows
• Ak is the cash
flow (payment or drawdown) of the current period, and
tk is the interval, expressed in years and fractions of a year
between the date of the first cash flow and the date of the
current cash flow. (t1 = 0.)
Conclusion:
Though all the points are not included in the formula , yet
this is the best way to judge the deal for loans. Once the loan
is decided then a detailed actual list of the payments is taken
from the lender and on the basis of that other decisions are
taken .The best use of this formula is the safeguard from fraudulent
lenders for borrowers who are not that much educated and do
not understand the intricacies of loantaking.
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