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Neither a borrower - explaining annual percentage rates

By | Published: Oct 14, 2009 | 22 Comments

Humans have a natural tendency to portray themselves in the best possible light. When the neighborhood kid who mows the lawn wants more money, he says his rate is lower than what the other kids are charging. When he gets together with the other kids, he brags about getting paid 20 percent more for the same amount of work.

Consumer credit companies, including mortgage lenders, are no different. When they're lending you money, they like to talk about their low APR, which stands for Annual Percentage Rate. When they're "borrowing" your money (by selling you a CD at the bank, for instance) they advertise their generous APY, which stands for Average Percentage Yield.

APR is the term relevant to mortgage borrowers. But it's useful to understand both, as well as a third concept—compounding.

When you're paying a simple interest loan at a rate of, say, 12 percent per year, it's easy to calculate its effect per month. It's 1 percent. At that rate, a $10,000 debt balance increases by $100 each month or $1,200 each year.

Enter the "magic" of compounding. Einstein called it "the most powerful force in the universe."

For the lender, the magic works this way. After one month, your new balance is $10,100. At that point, the lender starts charging interest not on $10,000 but on the new balance of $10,100. After a year (if you've made no payments) your balance is $12,268. Your simple interest rate was 12 percent but your APR worked out to 12.68 percent.

In fact, for the borrower, it's worse than that. Lenders don't compound monthly—most do it daily. That's the significance of the "daily periodic rate" you see listed at the bottom of your statement. The above 12.68 percent APR becomes something like 12.74 percent. (In a periodic rate, more "periods" means more interest.)

There is more you should know about APR. InvestorWords.com defines it as "the yearly cost of a mortgage, including interest, mortgage insurance, and the origination fee (points), expressed as a percentage."

The add-ons are man-made, not mathematical constructs. But clearly, they're of interest to borrowers when cross-shopping loan rates between banks. Just be sure the same number of points is factored into both figures, or you're comparing an apple to an orange.

Hey, what about APY? Again, that's more relevant when you're the lender. Buy a 12-month CD and the bank will advertise its great Annual Percentage Yield of 1.4 percent - which sounds a little better to you than the APR, which is 1.3-something. Hence, the magic works in your favor for once.

A related note comes from the Lessons for Life Department. Given a choice, be a lender, not a borrower. Better yet, be a bank.


By Likewow,  Mon Dec 28 2009, 12:57
Buy cash. Hoard your cash. Live in a car if you need to and wait for the market to fall to complete catastrophic collapse. Then appear with your bag of money and a smile. Bankers are simply muggers who put away their knives and guns and trade up temporarily to pencils.
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By AESB,  Fri Jul 30 2010, 07:53
Thanks for the CLEAR explanation1
By Dayle Doherty,  Wed Sep 22 2010, 11:53
1) I want the kid from your example to work at my mortgage shop! If he was quoting landscape rates and comparing profit margins at age 12, imagine how good he'd be now. (Except with his portfolio bragging and deceptive rate reductions, he probably grew up to be the failed founder of Taylor Bean).

2) The acronyms of the mortgage world are WHACK; Wholly Hackneyed And Confusing as Kafka (hey, you started with the literary references in your title). Acronyms dissected, the APR is simply the total amount that it costs a borrower to borrow the money. If you picture (or daydream, rather) of paying for your house in 100% cash there are some costs you wouldn't incur, like paying interest or mortgage insurance. The APR simply takes all those costs, rolls them into the life of the loan, and lets you know the true cost of taking out the loan.

3) Shopping APR seems like a pretty great way to get the best deals, unless you become so fixated on the rate that you don't calculate the payments and therefore forgo the savings. Avoid this by going to a well-respected mortgage brokerage and let them do the deal shopping for you. Most mortgage brokers have several different investing lenders and can capitalize on daily incentives, kinda like the Orbitz of the home loan world. Go and hear them out because you're never bound to a contract simply because you fill out an application with a mortgage broker, and since many survive due to their referral business, they are all about getting you the best deal.
By Fran Rokicki,  Sat Feb 26 2011, 13:36
At time of closing, actually, prior to that, you will receive a form from the bank that lets you know just what your annual percentage rate is. It is always a bit higher than the quoted loan rate. The print out will show you how your interest will decrease over the time of your loan payment. More monies will go towards the principal, as time goes by.
By MARCO HUAMAN,  Fri Apr 1 2011, 12:55
APR is a very simple concept; if you understand a little of finance... APR is the "Compounded interest" of the "Effective Rate".
APR, is the rate after taking in consideration the actual dollar amount when calculating the cost of financing in the long term; but at a Value of the Present.
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By Shawn Ryan Rosa,  Tue Dec 13 2011, 13:45
excellent article - explains APR perfectly
By Danil Tesenin,  Fri Jan 27 2012, 09:47
Thank you for this explanations I will post this for others to read. Depending on which side of the lending tree you stand on, banks and institutions have different motives for quoting different rates. Remember:let mortgage broker help you and do the thing.
By Michael Smith, MBA, MPM,  Tue Apr 10 2012, 11:54
APR is required to be disclosed within 3 days of loan application. Remember that my friends!
By Steve A Lender,  Wed Apr 25 2012, 10:55
The funny thing about APR is lenders have been known to manipulate this figure making shopping lenders by APR questionable, If you do not keep your loan for the life of the loan, your APR is almost irrelavant. You should be focusing on working with a mortgage professional who can advise you of stratagies to get your loan paid down with a few simple tricks of the check book. Simply write a second check for 1/12th of your mortgage payment each and every month and you will take your 30 year mortgage to 23.7 year mortgage. If everyone who refinanced and drop their payments simply added this back to balance reduction, they would save 10's of thousands of dollars.
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