What is APR on a mortgage? The note rate plus most lender costs, expressed as a yearly rate over the full term, so two offers with different points and fees can be compared on one number.
APR restates the cost of a loan as a single yearly rate. It takes the payment stream the note rate produces, subtracts the finance charges from the amount actually advanced, and solves for the rate that reconciles the two. That is why APR is at or above the note rate on every loan with costs: the borrower repays the full loan amount but received it less the fees. Its job is comparison. Two quotes at the same rate with different fees look identical on the rate and separate on the APR.
What sits inside it is defined by rule rather than by custom. Discount points, origination and underwriting charges, mortgage insurance premiums and some third-party fees the lender requires are finance charges and go in. Title insurance and title examination, the appraisal, the credit report, a survey and recording fees are excluded when they are bona fide and reasonable, so a loan can carry thousands of dollars of costs that never reach the APR. The other limit is the assumption underneath it: APR spreads the up-front costs across the entire term. A borrower who sells or refinances in year five paid those costs over five years, not thirty, so the cost they actually bore is higher than the APR said. It is a fair number for a loan held to term and a flattering one for a fee-heavy loan held briefly.
APR is also a compliance figure. Under 12 CFR 1026.22 a disclosed APR is accurate within an eighth of a percentage point on a regular transaction and a quarter of a point on an irregular one, and if the APR falls outside that tolerance before closing the lender has to issue a corrected closing disclosure and the three business day waiting period starts again. That is one of the three changes that resets the clock, along with a change of loan product and the addition of a prepayment penalty.
A worked example
Two $360,000 loans, both at a 6.5 percent note rate over 30 years, both paying $2,275 a month. The first carries $1,200 of lender fees and discloses an APR of about 6.53 percent. The second carries the same $1,200 plus one discount point of $3,600 and discloses about 6.63 percent. The note rates are identical and the payments are identical, and the tenth of a point between the APRs is the $3,600.
Questions people ask
Why is APR higher than the interest rate?
Because the rate prices only the money borrowed and the APR also prices the finance charges paid to get it. The borrower repays the full loan amount but effectively received it less the points and lender fees, and expressing that as a yearly rate lands above the note rate.
Should you compare loans on rate or APR?
Both, and on the cash figures behind them. APR is the better single number for two offers on the same loan amount and term, but it assumes the loan is held to term, so for a borrower likely to sell or refinance early the up-front costs on page two of the loan estimate say more than the APR does.