When you see a real estate advertisement that quotes a payment amount, it also must include a number called the APR. That stands for "annual percentage rate."

When you apply for a mortgage, the lender is supposed to mail you a "good faith estimate" and a "truth in lending statement" within three business days. The note rate is quoted, along with the APR.

The APR is always higher than the note rate you are quoted.

Why?

Partly because APR is a totally artificial number. It is not the note rate on the loan and does not determine your monthly payment. It is calculated according to a formula determined by the government and is supposed to provide a method for comparing one mortgage offer against another, even when the rates, points, and costs differ.

The APR is supposed to help you determine your "true cost" of borrowing.

What follows is a simplification of how the APR is calculated:

The lender totals up certain specific costs associated with the loan and the interest rate that was quoted to you. Those costs are subtracted from the loan amount you inquired about. That results in a figure lower than your loan amount. Then the payment for your loan is calculated "as if" it were the payment on that lower amount.

As a result, the APR is always higher than the note rate you are quoted. The only exception is when the lender pays for all of your costs, which is often referred to as a "no cost" loan. There really are costs -- the lender is just paying them for you.

Keep in mind that the explanation above is a simplification. Computers are used to actually calculate the APR. Loan officers do not sit down with a pencil and paper and figure it out, even using a calculator.

There is some guesswork involved. For example, adjustable mortgages have an APR, too -- but no one really knows what rates will do in the future. Also, no lender really knows all the costs until the loan actually closes (a subject for a future column) - that is why the Good Faith Estimate is called an estimate. Since costs affect the APR, it cannot be accurately quoted until the end of the process.

Even then, it is still a fictional number.

A loan with a lower interest rate and higher points could easily have a higher APR than a loan quote at a higher note rate and lower costs, but...

...your "true cost" of borrowing may depend more on how long you keep the loan than anything else. Paying more in points to get a lower interest rate may save you more money if you intend to remain in the property for a long time -- even though it has a higher APR.