It’s a common misperception that when you shop for a mortgage, all you have to do is look for the loan with the lowest annual percentage rate (APR) and you’re done. However, APR was really designed for consumer accounts like credit card loans and auto financing. It just doesn’t work that well for mortgage transactions, and here’s why.
APR Is Almost Never Accurate
How many people do you know who take out a mortgage and keep it for its entire 30-year or 15-year term? Probably not many, and that’s why APR isn’t accurate for most people. APR calculations assume that you are going to keep your mortgage for its entire term, so upfront fees are amortized over that whole period. This can really underestimate the true cost of upfront fees if you keep your loan only a few years.
If your loan fees are $3,000, for example, APR calculations assume that they’re $100 per year ($100 * 30 years = $3,000). However, if you refinance or sell your home after two years, the fees are really $1,500 per year ($1,500 * 2 years = $3,000).
According to Investopedia, the average homeowner only keeps a mortgage for about seven years. This chart illustrates what happens to a loans APR as its duration decreases.
Loan amount: $100,000 Rate: 5.00% Fees: $3,000
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.
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 thereafter). APR calculations for ARMs carry several assumptions with obvious flaws. (See APR and Adjustable Rate Mortgages)
When an ARM adjusts, the rate is calculated by taking the index that the loan is tied to (such as the T-bill or LIBOR) and adding a margin to it. The result is called a “fully-indexed rate.” So an ARM that’s tied to the 6-month LIBOR index, adjusting in July 2013 with a 2.5 percent margin will get a rate of 2.91% (2.5% + the T-Bill index rate, which was .41% in July).
When the APR is calculated for an ARM, it’s based on the assumption that the interest rate changes at its first scheduled adjustment and remains at that rate for the rest of the loan’s term. To skew things even more, the calculation assumes that the index in the future will be the same as it is on the day the APR is calculated. Does anyone really believe that in July 2018 the LIBOR index will still be .41 percent?
Of course not. So, while you can use APR to compare ARMs with the same terms, don’t expect it to be an accurate representation of the true costs of the loan.
To complicate your shopping a bit more, some indexes are quite volatile and change from day to day. So 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 and Different Loan Types
Finally, what if you’re trying to compare 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
APR: Those Wacky Calculators!
A quick online search turns up several APR calculators that purport to provide the APR of adjustable and fixed rate mortgages. If you run the same numbers through each calculator, however, you’ll often get different results – in some case, extremely different results. Why would this be the case? Because the government hasn’t said explicitly how lenders and other should calculate APR, only that they have to make a good faith effort. This should cause you to take all advertised APRs with a grain of salt.
However, the Office of the Comptroller of the Currency (OCC) has set up a site you can use to validate an APR calculation. This calculator from DecisionAid.com does produce results that match the government’s calculator, so feel free to use this to double check a lender’s APR calculation.
So, Is an APR Disclosure Worth the Paper It’s Printed On?
Only if you understand its limitations and use it correctly. See Using APR to Shop for a Mortgage to learn how to use APR disclosures and Good Faith Estimates to get the best deal on your mortgage.