APR – What You Need to Know Before You Shop

APR, or annual percentage rate, is supposed to make comparing mortgage quotes easier, and mortgage lenders are required by law to disclose it.

If you borrow $200,000 at five percent, you pay more than just the monthly interest. For example, your loan fees might be $4,000, which is two percent of your loan amount. Here's how the APR would be calculated for this example:

  • The $4,000 loan fee is subtracted from the loan amount, leaving $196,000.
  • The monthly payment on $200,000 at five percent is $1,074 (you can get this with a mortgage payment calculator). 
  • The interest rate for a loan amount of $196,000 and a payment of $1,074 is 5.178%. The higher your loan fees, the greater the upward adjustment.

APR helps you compare two loans with different costs and rates (but they should be the same types of loans, 30-year fixed, 5/1 ARMs, 15-year fixed, etc.). Or, you could use the Points Calculator to easily make your comparisons.

So should you go with the loan with the lowest APR? Not always.

Limitations of APR

APR calculations assume that you are going to keep your mortgage for the entire term (usually 30 or 15 years), so upfront fees are amortized over that entire period. Spreading the 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 keep the loan in the above example for only seven years instead of 30, your actual APR increases almost .5 percent to 5.610 percent! A mortgage with no fees and a 5.25 percent rate would be better for you if you keep the loan only seven years.

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. If you use the Points Calculator to compare loans, you’ll see how long you’d have to keep your loan to save by paying extra for a lower rate.

Adjustable-Rate Mortgages

The APR is even less useful as a predictor of the true costs of an ARM or hybrid ARM. APR calculations for ARMs carry several assumptions, and their flaws are very obvious. One assumption is that your interest rate is fixed at the start rate for the introductory period specified in your loan documents, then the future adjustment is calculated using present-day financial data. The values when the loan actually adjusts (perhaps years in the future) will almost certainly be different. As a result, APRs for ARMs can't really be relied on.

For example, a 5/1 hybrid loan with a 2.5 percent start rate might be based on the 6-month LIBOR index (these numbers are listed by publishers like the Wall Street Journal) plus a margin of three percent. On the day that the APR is calculated and disclosed, the LIBOR might be .76 percent, so the APR will be calculated assuming that in five years, the rate will be .76 percent plus the three percent margin, or 3.76 percent. However, in 2007, the 6-month LIBOR was at 5.8 percent, and if the 5/1 loan was disclosed on that day, the adjusted rate would be assumed to be 8.8 percent! It’s really just a guess.

In addition, some indexes that ARMs track are quite volatile and change from day to day. 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 identical loans.

APR to Compare Different Loan Types

Finally, suppose that you are looking at two loans--a 30-year fixed-rate mortgage at five percent, and a 5/1 hybrid ARM at four percent. The 30-year loan has an APR of 5.178 percent, and the hybrid ARM has an APR of 3.5 percent. 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?

Not much, which is why tools like the Points Calculator can be valuable. Most of the time, the loan with the best mortgage rate is also the loan with the highest fees. If you expect to sell your home in five years, the calculator will tell you if your monthly savings will recoup the cost of getting the lower rate before you sell. You can then be confident of choosing the best deal for you; and the best deal for you may not be the loan with the lowest APR.

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