Years ago the powers that be (the fed. gov, which is of course heavily influenced by lobbyist trade groups and big banks) determined that interest rates must be disclosed and advertised to the applicant in the form of an annual percentage rate, commonly known as “APR”. The purpose was that a mortgage applicant can easily compare offers from banks and lenders with one figure. However, the APR can be very misleading and sometimes should be ignored as you will see from the example below.
The annual percentage rate is a calculation that takes the note rate and all the fees associated with the loan and blends them together to get a new adjusted interest rate. Sounds good in theory, but in all practicality it doesnt work.
Here’s why: If you break down the APR you have the note rate and the closing fees associated with a loan. The note rate is self explanatory, it is what it is. The fees are where the APR gets skued, because it calculates them into an interest rate, but over 30 years. This gives very little weight to the closing costs and nearly all of the weight to the note rate. When evaluating a prospective mortgage these are equally as important and should be weighed equally when it comes to decision making. Therefore, when lenders are advertising an APR rate (which is what the new federal rules require, not the note rate) they load up the fees to get a slightly lower interest rate and this blends into a lower, more attractive APR rate.
Consider this example: Two mortgage offers
A. 30 year fixed at 3.875% with $2,750 in closing costs on a $300,000 mortgage. The new mortgage payment is $1,410.71.
B. 30 year fixed mortgage 3.500 with $6,2750 in closing costs on a $300,000 mortgage, or the same loan with 2
discount points to buy down the rate by .375%. The new mortgage payment is $1,347.13.
Comparing A to B the difference is a savings of $63.58 per month, but it costs you an extra $6,000. This means you have to pay the mortgage for 94 months (break-even point) before the $63.58 per month catches up with the $6000 you paid for it. So, most people would agree that A is the better deal. And the simple fact is the average homeowner holds their mortgage for far less than you would guess, most people now average less than 5 years paying a mortgage because of how often people tend to refinance.
Now let’s look at the APR here. Take a guess which one looks better in terms of APR? You guess it. The one that takes you 94 payments for it to pay off.
Option A has an APR of 3.95% and Option B has an APR of 3.73%. So because that extra $6K is spread out over 30 years it doesn’t effect the APR much to show the difference.
This could all be fixed if the closing costs were amortized over 5 years instead of 30, giving a higher weight to the closing costs in the final APR calculation. Even this is very conservative, as I advise my clients that the payment savings should pay for the additional cost in less than 2.5 years, as a general rule of thumb.
By the way, the example listed as option B is very similar to the rates being marketed and advertised on the web and in print by mortgage companies trying to entice you to call them. In today’s lending environment you would call this a teaser rate.
The craziest thing about the APR is that Federal Law Mandates that the mortgage industry use this exact APR calculation everywhere….and all the time. If I wanted to advertise a rate it would be illegal for me not to use this APR calculation to show the terms I am offering. Another way of saying it, Federal Law Mandates that the industry use an outdated and misleading calculation in all advertisements and disclosures as the single most important point of consideration and comparison!