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Shopping for a Mortgage: What APR Can't Tell You

 

APR, or annual percentage rate, represents the cost of your mortgage as a percentage of the loan amount. APR is supposed to make comparing and selecting the best mortgage rates easier, and mortgage lenders are required by law to disclose it.

If you borrow $200,000 at 5%, you are paying more for your loan than just the 5% monthly interest. For example, it might cost you $4,000 just to originate the loan. Since it cost you $4,000, your actual proceeds from the lender is just $196,000. In this way, the APR is a number that takes into account the effect of costs such as origination fees. Here's how the APR would be calculated given this example:

  • The $4,000 origination fee is subtracted from the loan amount, giving a total of $196,000.
  • The monthly payment on $196,000 at 5% is $1,095.
  • Working backwards to see what the interest rate is for a loan amount of $200,000 and a payment of $1,095, you get an interest rate of 5.178%.

To easily make this APR calculation, use HSH.com's APR calculator. For example, if you need to borrow $200,000, and you have the choice of two 30-year mortgages -- one with a 5% interest rate at 2 points (costing $4,000), the other with a 5.25% interest rate and zero points, which is the better deal? The results from the APR calculator tells you that the APR for the first loan is 5.178% and for the second loan is 5.25%.

So you should go with the first loan, right? It's not that simple. Since your APR is not your only consideration, choosing a home loan is not quite the black and white process these numbers would suggest.

Mortgage Shopping: Limitations of APR

APR calculations assume that you are going to keep your mortgage for the entire 30 years, so upfront fees are amortized over that entire period. Breaking down fees over a long period dilutes their effect on the APR. However, the average homeowner only keeps a property for about seven years. If you only keep that first loan for seven years, your actual APR jumps to 5.610%! So the loan with the lowest APR may not be the best deal at all. In general, if you aren't certain that you're going to keep the property or your mortgage for more than a few years, and you are choosing between two loans with similar APRs, it's usually best to select the one with the fewest upfront fees.

APRs to Compare Adjustable-Rate Mortgages

The APR is even less useful as a predictor of the true costs of a home loan if you are considering an ARM or hybrid ARM (loans with fixed rates for the first few years, then adjustable there after). APR calculations for ARMs come with several assumptions, and their flaws are very obvious. Aside from the influence of fees, the APR calculation is performed on the assumption that your interest rate is fixed at the start rate for the time period specified in your loan documents, then increases at its first scheduled adjustment to a fully-indexed rate based on a financial index, such as the T-Bill or LIBOR, plus a margin and remains there. Worse, it uses today's value for the index, when it's certain that the value when the loan actually adjusts will be different.

It is a technical flaw in the math used for calculating ARM APRs that would see your APR be less than the contract interest rate specified in your loan documents. As a result, APRs for ARMs can't always be trusted.

For example, if your loan was based on the LIBOR rate plus a margin of 2.75%, your fully indexed rate in early January 2010 would have been 3.18%. If your loan has a contract interest rate at 4% and was fixed for 3 years, your APR calculation would be based on the assumption that your rate is 4% for three years, then adjusts to 3.18% and remains at this rate for the final 27 years of your loan term (which of course it won't). This is obviously not accurate; a simple review of recent historical index values at HSH.com shows that LIBOR has run as high as 9% in the not too distant past.

In addition, some indexes are quite volatile and change from day to day. However, it may not be that meaningful to compare one lender's APR on Monday with another lender's APR on Friday, even if both involve the same index.

APR to Compare Different Loan Types

Finally, suppose that you are looking at two loans--a 30-year fixed-rate mortgage at 5%, and a 5/1 hybrid ARM at 4%. The 30-year loan has an APR of 5.178%, and the hybrid ARM has an APR of 3.5%. Which is the better deal? You can't tell from an APR disclosure. APR can only be used to compare two loans of the same kind -- a 15-year fixed loan to another 15-year fixed loan, for example.

So, What Good Is APR?

Essentially, nothing, but it is the best tool we have at the moment. Aside from all the issues above, certain fees may or may not be included in the APR calculation, depending upon the lenders refund policy if the loan does or does not make it to closing. Because of this, two loans with identical fees and terms can have different APRs, making direct comparisons a challenge.

Most of the time, the loan with the best mortgage rate is also the loan with the highest fees. The APR can help you compare loans with different rates and fees to select the best one, but it is at best an imperfect tool. A better method might be for you to calculate your own actual APR, instead of the hypothetical one you see in advertisements. Use HSH.com's APR calculator to do the math.

If you know that you won't keep your loan for its full term, adjust the term in your mortgage calculator to make sure that you choose the best deal for you; and the best deal for you may not be the loan with the lowest APR on your Truth-in-Lending disclosure form.

Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.

 

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