Your Mortgage Rate Sets the Payment, but the APR Counts the Fees
The APR exists because a senator kept insisting borrowers deserved one honest yearly number, and his idea outlasted his Senate career. It is still useful, as long as you know which fees it leaves out and how long it assumes you will keep the loan.
In 1960 Senator Paul Douglas introduced a truth-in-lending bill, asking lenders to state the real yearly cost of credit in a single number. It went nowhere for years. The chair of the Senate banking committee, A. Willis Robertson, opposed it. Then, in the 1966 election, Douglas and Robertson both lost their seats, and the idea Douglas started passed the Senate 92 to 0. I love that ending: the sponsor lost his job and his bill won unanimously anyway.
President Lyndon Johnson signed the law on May 29, 1968, and its rules took effect on July 1, 1969. The number it gave every borrower is the annual percentage rate, the APR you will see next to your interest rate on every mortgage offer.
Two numbers answering two questions
The interest rate answers "what will my monthly payment be?" The CFPB defines it as the yearly cost of borrowing the money. The APR answers a broader question, "what does this loan really cost?", by folding in points, mortgage broker fees and other charges you pay to get the loan. That is why the APR is usually the higher of the two.
The problem Douglas was chasing was real. Some lenders of the era charged interest on the original loan amount even as it was paid down, producing a true annual rate that, according to one history of the act, was sometimes as high as twice the stated rate.
What the APR leaves out
Here is the part most explainers skip. Regulation Z, the rule that implements the law, counts points and loan fees in the finance charge. But for a loan secured by real estate it excludes a list of real-estate fees, provided they are bona fide and reasonable: title examination and title insurance, preparing loan documents, notary fees, appraisal fees and amounts paid into escrow, among others. So the APR is not your total closing bill. It is a yardstick for the lender's own pricing.
There is even a built-in wobble. Federal Reserve examination procedures treat a disclosed APR on a regular mortgage as accurate if it falls within one-eighth of a percentage point of the correctly calculated figure.
A quick gut check still works, in my view. When the APR sits only a little above the note rate, the lender's fees and points are modest. When the gap is wide, something upfront is large, and it is worth finding out what before you sign. In the example below, $5,500 of charges on a $400,000 loan opens a gap of roughly 0.14 percentage point.
The five-year catch
The APR spreads upfront costs across the loan's full term. Real borrowers often do not stay that long. I worked an example to see how much that matters.
A worked example
- Loan
- $400,000, 30-year fixed at 7.00%
- Charges counted in the APR
- $5,500 (one point of $4,000 plus $1,500 in lender fees)
- APR over the full 30 years
- about 7.14%
- Effective yearly cost if paid off after 5 years
- about 7.34%
Same loan, same fees, and the cost is a fifth of a point higher for the person who moves after five years, because the upfront money is spread over fewer months. That makes APR slightly flattering to loans with heavy points if you do not expect to keep them. For adjustable-rate loans the CFPB adds a separate caution: the APR does not reflect the maximum rate the loan could reach.
Using it well
On the Loan Estimate the APR sits on page three, where the CFPB calls it "one measure of your loan's cost," next to the Total Interest Percentage and the "In 5 years" line. My advice is to compare APRs only between loans of the same type and term, which the CFPB also recommends, and to lean on the five-year line if you expect to move or refinance.
Douglas wanted one number that made hidden costs visible. Nearly six decades later it still does that job, provided you remember it was built for a borrower who keeps the loan for its whole life.
Sources
Every factual claim above traces to one of these. Links open in a new tab.
