Many people think that the annual percentage rate (APR) is “always” higher than the stated interest rate because the majority of advertised mortgage rates show APRs that ARE higher. However, you could go wrong (in an expensive way) by assuming that the APR is “always” higher, just as you could choose the wrong loan if you assume that adjustable rate mortgages “always” go up.
In fact, these two misconceptions are related.
Adjustable Rate Mortgage APRs
On July 9, 2013, LendingTree lenders advertised a 5/1 ARM with a rate of 3.63% with an APR of 3.42%. It wasn’t a misprint.
The lower APR is based on the way lenders calculate APR for adjustable rate mortgages. When they disclose the APR for an adjustable mortgage, lenders are pretty much flying blind. They don’t know what rates will be in the future, so they disclose under the assumption that the loan will adjust in the future the way it would adjust if it were resetting that day. They also assume that the loan remains at that rate for the rest of its life.
On July 9, the 6-month LIBOR index, which is the basis for resetting a lot of 5/1 mortgages, was only .41 percent. So, while people taking out a new 5/1 loan on July 9 might have been offered a 3.63 percent rate, many homeowners with a 5-year-old 5/1 loan were seeing their mortgage rates drop to something like 2.91 percent! And disclosures being printed on July 9th could assume that in five years, those loans will drop to something 2.91 percent and stay there for the remaining 25 years of the loan’s life.
Rates five years from now aren’t likely to be exactly the same as they are today, but that’s how APR disclosures work, and that’s the first reason that APR might be lower than the stated rate. Now for the second reason.
The other reason that a loan’s APR might be lower than its stated rate is the existence of rebate pricing. Any time you shop for a mortgage, you can choose from several pricing structures. You might pay $1,000 for a $100,000 mortgage at 5.25 percent, or $3,000 for a loan at 5.00 percent, or $6,000 for a loan with a rate of 4.875 percent. But there’s a flip side.
You might also choose a mortgage with a higher rate, for example 5.40 percent, in exchange for a rebate of $1,000. In that case, your mortgage fees are actually negative, so your APR will be lower than your stated interest rate.