Aug 4, 2017

APR is the government's attempt to confuse you.  Just kidding.  Sorta.

The APR (or Annual Percentage Rate) is the cost of obtaining a mortgage loan expressed as an annual rate.  Its purpose is to show the total annual cost of a mortgage (including closing costs) over its full term (usually 30 years).  APR is intended to be a tool to help customers compare the costs between different mortgage loans.

APR is not used to calculate your monthly payment.  The interest rate that is used to determine your monthly payment is the note rate.  APR is almost always different from the note rate because APR considers (some) closing costs along with the note rate.  If your closing costs were $0, your interest rate and your APR would be the same.

Mortgage shoppers are confronted with APR as soon as they begin shopping for loans.  Government regulations require lenders to disclose APR along with interest rates in advertising.  Mortgage lenders are also required to disclose APR on a Loan Estimate when consumers apply for a mortgage loan.

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Calculating APR
Theoretically speaking, if you were comparing two different mortgage loans, the loan with the highest APR would also have the greatest cost.  The rationale of this rule is that the APR reflects both lender fees and the interest rate, and is therefore a more comprehensive measure of cost to the borrower than the interest rate alone.

The idea is to require lenders to provide one uniform set of price disclosures that are consistent from loan to loan, and from lender to lender.  Then consumers can compare prices across loan types and across lenders.

So why doesn't it work?

Deficiencies with APR

  • Application Disparity - In my opinion, the greatest problem with APR is that lenders don't apply the same fees in determining APR.  Some (but not all) closing costs factor into the APR equation.  For instance, some lenders consider a credit report fee in calculating APR.  Others don't.  Some lenders consider a flood certification in calculating APR.  Others don't.
     
  • Easy Manipulation - APR can also be easily manipulated.  Prepaid interest (interest paid on the loan from the day of closing through the end of month) is one charge that factors into APR.  However, if you're comparing loans from two different lenders, they could each estimate different closing dates and therefore quite different APRs.  Lender A may quote prepaid interest for two days.  While Lender B quotes prepaid interest for 25 days.  That could affect your APR when, in reality, your choice of lenders has little effect on your closing day.
     
  • Loan Not Kept to Term - In addition, APR assumes you'll keep your loan for the entire term (usually 30 years).  In reality, most people sell their homes or refinance their mortgages before the end of the term.  How many people do you know who buy a house and keep the original mortgage for 30 years?
     
  • Adjustable Rate Mortgages - On a fixed rate mortgage, the interest rate remains the same over the life of the loan.  The addition of certain closing costs to the interest payment results in an APR above the note rate.

    On an adjustable rate mortgage (ARM), however, the initial interest rate holds only for a specified period of time.  In calculating an APR, some assumption must be made about what happens to the rate at the end of the initial period.

    Since nobody knows where interest rates will be at the end of the initial period, APRs for adjustable rate mortgage are hypothetical.  In fact, the APR on some ARMs today are below their initial interest rates!

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  • Mortgage Insurance - If your loan comes with private mortgage insurance, APR assumes the mortgage insurance will be canceled at a certain point (usually when the loan is scheduled to reach 75-80% of the original value of the home).  But private mortgage insurance is not always canceled at a specific point in time.  A home may increase in value or a borrower could choose to pay down the balance of the loan to cancel MI sooner.
     
  • Compare Apples to Apples - Like comparing interest rates, consumers must shop for the exact same mortgage loan at the exact same point in time to have an accurate comparison between two or more lender's APRs.  Because interest rates change daily (sometimes more than once), an interest rate and APR from Lender A on Monday can't be compared to a quote from Lender B on Tuesday.

So should you ignore APR calculations?  Definitely not!  But I wouldn't use APR as my only method of comparing one loan program (or lender) to another.  Carefully compare estimates of both closing costs and APR and ask your lender to explain any disparities.