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Understanding the APR
Although it is intended as a tool that will enable consumers to understand the cost of credit and to compare the cost of loans offered by different creditors, the annual percentage rate can create confusion. The confusion arises from the fact that the interest rate on a loan and the APR are rarely the same. For example, a borrower who has an interest rate of 6% on a loan may wonder why the APR is listed on a statement as 7%.
The difference between the APR and the interest rate occurs because the APR includes not only the interest rate, but also all allowable fees and charges that are made at the time of closing. The interest rate and the APR will be exactly the same in lending transactions in which the borrower pays all closing costs outside of closing. However, since closing costs are frequently financed, and because the APR represents the total cost of credit, including any fees paid in order to obtain it, these two numbers are not often the same. For example, suppose that a borrower obtains a loan for $100,000.00 with an interest rate of 6%, and that the fees which he/she pays for settlement services, credit insurance, debt cancellation fees, and other allowable charges equal $10,000.00. If the borrower pays these fees upfront, the interest rate and the APR will both remain at 6%. However, if the borrower finances these fees, the interest rate will be 6%, but the APR will be calculated for $110,000.00, and will be higher.
Calculating the APR
Regulation Z provides that the APR "...shall be determined in accordance with either the actuarial method or the United States Rule method." 12 CFR Section 226.22. Appendix J in Regulation Z sets forth the steps for calculating the APR for closed-end credit using both methods, and Appendix F outlines the steps for calculating the APR for open-end credit. A copy of Appendix J is included at the end.. A review of it shows that the computation of the APR is complex. Due to the complexity of the calculation, it is one that is frequently made using software. A windows-based version of the Annual percentage rate program is available on the website for the Office of the Comptroller of the Currency (OCC), and it is free, if downloaded from the OCC site. http://www.occ.treas.gov/aprwin.htm.
Errors in Calculating the APR
The regulations applying to both open-end and closed-end credit address errors in the calculation of the annual percentage rate. The regulations provide that an error is not a violation of the law as long as the violation resulted from "...a corresponding error in a calculation tool used in good faith by the creditor..." and the creditor discontinues use of the tool and advises the Board, in writing, of the error in the tool. 12 CFR Section 226.22(a). In Staff Commentary which it has drafted on Regulation Z, the Board has emphasized that the types of errors which are not likely to lead to liability are those directly attributable to the calculation tool itself, including software programs, and that creditors will not be absolved from liability for errors arising from improper use of the tool, from incorrect data entry, or from misapplication of the law.
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