Just what is rolled into an annual percentage rate?

Recently, one of our clients was signing loan documents and asked why the annual percentage rate (APR) on her disclosure documents was higher than the interest rate shown on her note. She wanted to be sure she wasn't getting any unexpected surprises. This was a good question and we thought it would be good to share the explanation.In this case, the loan was for $202,500, had a fixed rate for 15 years, and the interest rate on the note was 5.5 percent. However, the APR was 5.631 percent. What is the APR and why is there a difference in these two rates?The APR is a measure of the cost of credit, expressed as a yearly rate. Federal laws that govern the APR are in regulation Z of the Truth in Lending Act which prescribes types of prepaid finance charges that should be added to the cost of credit, in addition to the interest that is paid during the life of the loan. Examples of charges included in the APR are prepaid interest, points and loan fees. Excluded items are title insurance, escrow fees, notary fees, credit report fees and appraisal fees. This borrower's good faith estimate reflected prepaid interest of $885, lenders fees of $600, broker processing fees of $330 and other loan fees of $277, for a total of $2,092. These prepaid finance charges are added to the 5.5 percent interest during the life of the loan ($95,328), giving us total finance charges of $97,420. The formula also requires that the prepaid finance charges of $2,092 be subtracted from the loan amount to obtain the "amount financed." The computer program then calculates the APR of 5.631 percent.To see how the APR varies, let's do a "what if" scenario. What if we charged two points, or 2 percent of the loan amount, for loan origination fees? In that case, the finance charges would be $4,050 higher, the amount financed would be lower, and the APR would be 5.948 percent. Thus, the higher the spread between the APR and the note rate, the more the finance charges. When shopping for a loan, look out for large differences.The example shown is for a simple, fixed interest rate loan and is easy to follow. APRs for variable interest rate loans are more complex and will be explained in a future column.Even though the above example answers our client's question on the calculation of the APR, don't be fooled. Under regulation Z, lenders are allowed 0.125 percent leeway in their estimates for the calculation of the APR. In addition, lenders interpret the regulations differently and don't necessarily include all items in the APR. To avoid getting lured in by misleading advertising, ask for a good faith estimate up-front that spells out all of the specific costs of your loan. This is the best way to compare lenders and avoid any unexpected surprises.Mike Ferguson is the owner of Windsor Financial Services located in Granite Bay. His e-mail address is windsor@quiknet.com