What Does APR Mean and How Is It Calculated?

When you hear mortgage ads, apply for a mortgage, see a mortgage rate advertised, you will always see the APR right next to the interest rate.  Why is that, and what is the APR?

APR stands for Annual Percentage Rate.  The APR is a calculation that determines what your interest rate would be if you removed the fees from your loan.  The higher the fees the further your APR will be away from your actual interest rate.  The lower the fees the closer your rate and APR will be.

The Annual Percentage Rate is more a measurement of Fees than it is rate.

TIL or the Truth in Lending Law requires that the APR must be displayed with any advertised rate. This is so companies cannot advertise extremely low rates and then tack on high amounts of fees you would then be required to pay to get that rate.

Go ahead and look.  You will never see an add or hear a radio commercial for a mortgage rate without also getting the APR.  Just like you will never see someone in a television commercial actually drinking beer (or any alcohol for that matter), they cannot show the consumption of alcohol.  I guess that is a different article for a different blog though.  Back to APR.

How is APR Calculated?

APR is calculated by first determining the payment of your loan then removing certain fees like points, application fee, closing cost, processing fee, title fee, etc, from the total loan amount and recalculating a new rate from the remaining balance and original payment.

Here is an example.

Let’s say your loan looks like this

  • $100,000 Loan Size
  • 4% Rate
  • 30 year term

In this scenario your mortgage payment would be $477.42.

The closing costs included in the $100,000 were $1,500.

APR would be determined by first removing the fees from the loan size.

  • 100,000 – 1,500 = $98,500

Now calculate a new rate (the APR) using

  • $98,500 Loan Size
  • $477.42 payment
  • 30 year term

The rate calculated here is 4.1257% which would be your APR.

So the whole scenario would be

  • Loan Size: $100,000
  • 30 Year Term
  • $477.42 payment
  • 4% rate with a 4.126% APR

This is how you can see the APR is more a measurement of fees than it is rate.

You can use this information to help determine what advertised loans are better than others.  If you see a 3.5% rate with a 4.5% APR compared to a 4% rate with a 4.2% apr you know which loan is going to be much cheaper and probably the better deal.  Even though option one may have had a lower rate.

What are Adjustable Rate Mortgages (ARM)?

Many people are unaware that taking on an adjustable mortgage rate can significantly lower mortgage rates. These loans, otherwise known as ARMs, are basically special types of mortgage loans. Often, homeowners can find lower rates on mortgage payments in the beginning years of their loans.

Fixed Rate vs. Adjustable Rate Mortgages

Most mortgages operate as fixed rate mortgages. This means the interest rate stays the same for the duration of the mortgage. You’ll pay the same amount every month on your premium, unless you refinance or pay off your loans early.

The interest rates on ARMs will change depending on prevailing interest rates. Many adjustable rate mortgages are tied to the LIBOR index, the Treasury Securities Index, the Cost of Funds Index, or a variety of other indexes.

Term Fluctuation
Your rate will adjust depending on the terms of your adjustable rate mortgage. These rates are adjustable every six months, every year, or even every several years.  Adjustable rates are usually good for people who are paying off a condo or a short term home - if you plan to keep the home for 5-10 years you can refinance once and pay back the loan when you sell the house. This allows you to pay a lower interest rate throughout the life of your loan while not incurring the higher interest rate that kicks in after the initial 5 years.

A Good Short Term Option
Remember that adjustable rates will benefit you in the short term, but if interest rates rise, you could end up paying more than you bargained for.

Analyze all your options to determine if a fixed rate mortgage or an adjustable rate mortgage would be better for you.

What are Health Savings Accounts (HSA)?

A Health Savings Account (HSA) is a new form of consumer directed health coverage pairing a high deductible health plan with a tax-free savings account. Designed to reduce healthcare insurance costs for employers and employees, the high deductible policy provides protection against major medical expenses - the HSA is used to pay for day-to-day medical expenses.

The savings product offers individuals an alternative method of paying for their health care. HSAs enable individuals to pay for qualified medical expenses on a tax-favored basis. Contributions are tax-deductible and eligible contributions are tax-free.

Individuals control the money in their HSA. Decisions on how to spend the money are made by the individual without relying on a third party or a health insurer. Funds not spent can carry forward to future years and be used penalty-free after age 65 for any purpose seen fit.

Advantages of Heath Savings Accounts:

  • Security-High deductible insurance in conjunction with a Health Savings Account protects against high or unexpected medical bills.
  • Affordability-Lower health insurance premiums by switching to health insurance with a higher deductible.
  • Flexibility-Utilize funds to pay for current medical expenses, including expenses that an insurance policy may not cover, or save the money in the account for future needs.
  • Savings-Earn interest on money in an HSA for future medical expenses and grow your account year after year, just like an IRA. There are no "use it or lose it" rules for HSAs.
  • Control-Make all the decisions about how much to put into the account and how to spend the money.
  • Portability-Accounts are completely portable. Keep and HSA in the event of a job change, medical coverage change, become unemployed, move to another state or change marital status.
  • Tax Savings-An HSA provides triple tax savings: tax deductible contributions, tax-free earnings and tax-free withdrawals for qualified medical expenses.

What are Fixed Deferred Annuities?

Imagine a CD-like product with lots of fine print "gotchas" and you've got a good idea of what a fixed deferred annuity is. When presenting this product to prospective buyers, the insurance sales person will usually talk up all the good features, including a "teaser" interest rate that's higher than those being offered on bank CDs and sometimes even a "bonus" for buying the product. What they fail to mention, or mention in an oblique way (such as "this is a nine-year product"), is that the higher-than-normal interest rate might only be guaranteed for a short period (perhaps one or two years).

After that guaranteed period, the interest rate may revert to a below-market yield, but you're locked into that low yield by a high surrender fee that may last for up to 15 years. And, if you take your money out and you're not yet 59.5 years of age, you'll pay a 10% early withdrawal fee in addition to the surrender fee. Because of the surrender fee and the 10% IRS penalty for early withdrawal, unsuspecting investors often find themselves "trapped" in this low-yielding fixed annuity when much better investment options are available.

While fixed annuities might be sold as "similar to CDs," they are not guaranteed by the Federal Deposit Insurance Corp. And since fixed annuity assets are co-mingled with the insurance company's operating assets, they are subject to seizure by creditors should the insurance company suffer a financial setback. Fixed annuity products aren't considered to be securities, so there is no prospectus. The only information available to the consumer is the insurance company's marketing material and the insurance agent's sales pitch.

(An Equity-Indexed Annuity (EIA) is another type of annuity that is currently classified by the insurance industry as a fixed annuity, but the Securities & Exchange Commission disagrees and is taking action to have them declared securities. We'll cover EIAs in a later column.)

The ability for a fixed annuity to pay the guaranteed amount is based solely on the financial well-being of the insurance company you invest with. Because of this, the SEC suggests investors should purchase deferred fixed annuities from insurers receiving the highest credit worthiness ratings from these five insurance rating firms.

What is a Certificate of Deposit (CD) Ladder?

certificate of deposit ladder is an investment strategy used to invest in certificates of deposit when interest rates are rising. Interest rates and CD rates usually rise when the economy is expanding and the Federal Reserve is raising rates to keep inflation in check.

Locking into longer term certificates of deposit when CD rates are rising may prevent you from taking advantage of an increase in CD rates. One way around this is investing in a certificate of deposit ladder. The strategy used in a CD ladder is to evenly spread out your deposits over a period of several years. In the end all your money is deposited in longer term certificates of deposit which pay a higher CD rate.

Let’s look at an example certificate of deposit ladder. We will use a three year CD ladder with $30,000 for this example. You invest $10,000 in a 3 year CD, $10,000 in a 2 year CD and $10,000 in a 1 year CD. After year one, the 1 year $10,000 CD matures, the CD investor then invests the money in a 3 year CD.

After year two, the 2 year $10,000 CD matures, the CD investor invests in another 3 year CD. After two years all the money is invested in 3 year CDs at a higher interest rate. In a raising rate environment, this allows you to get increasingly higher CD rates.

In a falling rate environment it makes more sense to lock in your money at the highest CD rate possible.