Today, Dr. Don explains how to calculate an APR and discusses the financing options for a home improvement project.

Calculating the APR

Dear Dr. Don,
How is the annual percentage rate (APR) calculated on a home mortgage? How is it different from the interest rate on the mortgage?
Calculating Consumer

Dear Calculating,
The nominal or periodic interest rate on a mortgage loan is used to compute how much you will pay in interest each month. It's not a good idea to choose a loan solely on the periodic rate because you aren't considering how closing costs, origination points, discount points and mortgage insurance influence the effective interest rate of the loan. Since these additional costs vary between lenders, they muddy the waters when consumers try to comparison shop for a mortgage loan. These costs are considered when computing a loan's APR. The Truth-in-Lending Act requires lenders to provide consumers with a loan's APR, which they can then use to compare loans.

Bankrate.com always provides you with the loan's APR and provides some of the additional expenses that are part of the APR calculation. The problem with choosing a loan based on APR is that lenders have some flexibility in how they account for loan costs when calculating the APR, and they can understate a loan's APR by 1/8 of a percentage point -- 1/4 percent if the loan is an irregular loan -- and still be considered to be in compliance with the law.

If you want to make sure there's consistency across loans, why not calculate the APRs yourself? Wheatworks Software has an APR calculator that you can download to perform your own calculations. It's a shareware package that you can try out before deciding to buy.

Financing home improvements

Dear Dr. Don,
We would like to update our home by adding a room in the basement. Our adjustable rate mortgage is currently set at 8.12 percent and we owe $50,000 on the note. The house is worth about $85,000. What kind of loan should we take out for the home improvement?
Betty Bungalow

Dear Betty,
You have several options: refinance, take out a home equity loan, or open a home equity line of credit. It sounds obvious, but choose the option that is the least expensive for you. Interest rates on a first mortgage will be lower than the home equity line of credit, which in turn will be lower than the home equity loan. But closing costs and other loan-related costs could swing the decision toward one of the home equity loans.

Realtor.com has a mortgage comparison checklist that will help you determine the costs for each type of loan.

You might also consider the government's Title One loan program. You can read about it in Michael Larson's story of May 4. You might also want to check out Salvatore Caputo's story on financing a home improvement.

I like the option of refinancing to a fixed-rate mortgage. The increases in short-term interest rates over the past year have made ARMs less attractive. Assuming your appraisal comes in where you think it will, refinancing will allow you to raise about $18,000 in cash while keeping 20 percent equity in the home. By keeping the loan-to-value at or below 80 percent, you can avoid paying private mortgage insurance (PMI) on the loan. If you expect the project to cost more than $18,000, you'll still have the same options, but the cost of the refinancing option will include PMI payments. As long as you don't go over 100 percent loan-to-value, the interest expense should generate a tax deduction from all three of the options.

Don't want to spend the next 30 years paying off the remodel? Home equity loans typically have a 10- to 15-year payoff, but you can accomplish the same result by making additional principal payments on a 30-year mortgage.

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-- Posted: Aug. 16, 2000