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What to Know about APR vs Mortgage Rates

by James Swift

What You Need to Know about APR vs Mortgage Rates

So, you are looking for a mortgage loan. You want the lowest rate on your mortgage. Doesn't everyone? Finding a good deal on a home loan is not as simple as some think. There is a ton of information to sift through online about buying a mortgage. Ad a lot of it is very confusing.

That's why many potential home buyers turn to the APR or annual percentage rate to determine how much their loan payment will be. The APR is theoretically supposed to tell you what the true, bottom line cost of your mortgage will be over time.

APR is not all it is cracked up to be, however. When you are shopping by looking at APR, you may not choose the best loan for your situation. Fact: APR is one of the easiest to manipulate numbers in the mortgage industry. And many lenders expect that you will not know that.

Remember, APR is not the sole way to compare mortgage. It is a single way, but there are others.

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APR Basics

APR is a math formula dreamed up by the government. It is intended to measure what the long term cost of a loan is from the date you close until the day you pay it off.

APR is measured by taking the original loan, adding in closing costs and pre-paids, and then making an estimate about how many dollars need to be paid over the life of the loan to pay it of fully.

With a 30-year fixed mortgage, the term of the loan is 360 months. For a 15-year mortgage, it is 180 months. There is even a 40-year home loan that is becoming very popular again in 2018.

APR is trying to tell you, if you borrow this amount of money and it costs me this much to pay off the loan, what would my mortgage rate have been?

APR is splashed all over the place, especially in the truth in lending disclosure. Loan officers have to tell you what the APR of the loan is every time they give you a quote. This is designed to protect you the consumer. The government says by showing the APR with every mortgage loan rate quote, you will be able to make a better decision. And this is true, sometimes.

However, in many cases, APR fails miserably because it cannot really be an 'apples to apples' comparison that it claims to be.

Remember the loan with the lowest APR might not be best for you.

APR Details

Banks and lenders love to push the 'low APR' stuff, especially online. Most online mortgage companies list their mortgage loans by APR. This means that the lowest APR loans come up first. This can really mislead people. Low APR does NOT always mean a great deal.

Here is why APR is quite flawed.

When a lender determines what the APR will be, it is making an estimate of your long term loan costs. To do that, the lender is predicting the future. It is making some serious guesses about what might happen down the road. Here are common assumptions made with APR calculations:

  • The formula assumes you will keep your loan for 30 years; most don't.
  • The formula assumes you will never pay extra some months; many do.
  • The formula assumes you will never do a mortgage refinance; most do.

And, for loans that have PMI or mortgage insurance, the APR formula assumes a certain month and year that your home with get to 20% equity. This is impossible to predict, so APR largely fails.

Another problematic example is discount points. When comparing a loan with discount points to one without, the loan with points will almost always show a lower APR, even if the loan is not really cheaper.

Loans with upfront points have fees and can be a bad choice if you intend to live in the home less than a decade.

Lenders know this. They don't care. Requiring big discount points makes the deal look great, but the loan may actually be more expensive.

APR Assumes You Won't Sell or Refi

Loan fees play an important role in what you pay on your loan. Final loan costs are unknown when the mortgage company makes its Good Faith Estimate. But the costs are figured into the APR, so if the costs are estimated, the APR is an estimate.

The APR formula that the government mandates makes similar errors with adjustable mortgages. The adjustments will affect your future payments and the APR, but there is no way to accurately predict what future rate adjustments will look like.

So, a bank that assumes the smallest rate adjustments can show the lowest APR.

See how lenders can game the APR calculation to their advantage?

How to Shop for a Mortgage Effectively

Experts say you should not shop by APR; instead, pick the rate that you want, and then look for the fees at that rate. Or, you can select a zero-closing cost mortgage and show for a rate with zero fees added in.

So, you should fix a single piece of the mortgage puzzle into place and then look for the other piece.

For instance, if you see a 30-year fixed rate at 3.5%, and you get three quotes from lenders at that rate with fees from $1500 to $3000, you know the one with the cheapest closing costs is best.

This is better than trying to compare a 3.5% rate at $3000 in closing costs with 3.625% at $500 with closing costs. The 3.5% rate could show a lower APR but cost you more.

You also can shop three lenders by asking for no closing cost rate quotes. Whichever one is lower rate wise, you know is the best deal.

The Bottom Line

Remember, do not shop for rates and fees at the same time or you may end up with a more expensive loan. APR is useful but can be confusing and misleading, so follow the above advice and you should have a better outcome with your loan shopping.


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