When you shop for a mortgage, you look at the interest rate, the terms, the costs and the annual percentage rate, or APR. Many advisors recommend choosing the loan with the lowest annual percentage rate because that calculation includes not just the mortgage interest but also the costs of securing the loan, including origination fees, discount points and other costs.
The Truth-in-Lending Act (TILA) requires mortgage lenders to display the loan's annual percentage rate whenever a loan's interest rate is advertised. This disclosure is supposed to make it easier for consumers to compare mortgages with different pricing and rates.
While it's obvious that Loan A, a $100,000 mortgage costing $1,000 with a 3.75 percent rate is a better deal than Loan B, which has the same rate but costs $3,000, most comparisons are not that straightforward.
For example, what about Loan C, a $100,000 mortgage costing $3,000 with a 3.625 percent rate? Which is the better deal? Loan A's annual percentage rate is 3.831 percent, and Loan C's is 3.856 percent. As long as both lenders included the same fees in their calculations, Loan A is the better deal.
How Does APR Work?
So how does an annual percentage rate calculation work, anyway? It incorporates the costs of financing, not just the interest rate. For example, Loan A in the example above has $1,000 in costs. So if you borrow $100,000, you're really getting $99,000. However, your payment of $463.12 is based on a $100,000 loan amount. So the 'real" interest rate is higher than 3.75 percent – it's actually 3.831 percent.
This is just fine when you are the one doing the calculations and you know which fees you've included. But what about mortgage advertisements created by the lender? You don't know exactly which costs have been included in the annual percentage rate, because the TILA does not specify which costs musts be included. Lenders get to pick and choose which fees they incorporate into their APRs.
Even the Consumer Financial Protection Bureau (CFPB) uses a few "weasel words" in its annual percentage rate description. For example, the CFPB states that "an APR might not include a charge, such as a credit report fee in a real property transaction."
CFPB documents explaining the Truth-in-Lending Act state that APR s are a function of:
- The amount financed, which is not necessarily equivalent to the loan amount.
- The finance charge, which is not necessarily equivalent to the total interest amount
- The payment schedule, which does not necessarily include only principal and interest
"Normal" APR Disclosures
Even though there is no standard disclosure requirement, lenders do have conventions and customs, and many disclose their costs in the same way. For example, these fees are usually included in an annual percentage rate disclosure:
- Discount points (prepaid interest)
- Loan origination
- Loan processing
- Document drawing
- Appraisal review
And these charges are often not included:
- Title insurance and escrow services
- Credit report
- Home inspection
- Document preparation
How to Compare Mortgage Offers
If you're comparing two offers with similar APRs, ask each lender for a Good Faith Estimate (GFE), which lists all the expenses associated with obtaining the mortgage. Lender are required to provide this within three business days of your loan application date, but many will supply a GFE to consumers who are shopping for their mortgage and have not yet applied for a loan.
If you're using LoanExplorer by LendingTree to search for loans and compare offers, just click the "+ Details" link under any offer and you'll see the loan costs, including estimates for mortgage insurance, the estimated payment and the APR. These details do not include third party charges like appraisal fees and title insurance; they show the lender's charges, and that makes the analysis easier.
By comparing the list of loan fees, you should be able to make an informed decision. Keep in mind that you can select the provider of some services like title insurance and escrow services. You might want to compare just the lender fees when choosing between two loans to avoid confusion. Understand also that GFEs are estimates, but lenders are required to be accurate within specified limits. If the actual charges exceed those limits, the lender must refund the excess to the borrower.