Federal Regulation places a high degree of emphasis on the APR calculation, believing that consumers can make better choices when presented with the APR. APR stands for annual percentage rate. However, the APR calculation is flawed for this reason: It factors the interest rate and costs over the life of the loan, which in most cases is 30 years. The problem with this is that very few people hold a particular mortgage for 10 years, let alone 30 years. These days most mortgage loans are only in place for 4-5 years, meaning that a homeowner will on average refinance or sell their home after 4-5 years.
This statistic is crucial because it means that, on average, a homeowner has less time to recoup closing costs that anticipated. I have been originating loans day in and day out since 2006, and I can promise you most people, when getting a new mortgage, expect to have it much longer than 5 years. It can be hard to anticipate life’s changes that often result in a change in the mortgage. So given this reality, I advise my clients to make sure that all closing costs are recouped within 2 years, or immediately, by doing a no cost loan. By sacrificing .125% in rate you can save thousands in transaction costs and still save on a monthly basis.
Here is an example, on a $300,000 mortgage you may have two options:
A. 3.5% with 1 point (or 1% in discount fee) and $2000 in closing costs. APR is 3.633 and the total cost is $5,000, $2,000 in closing costs and $3,000 for the 1 point. Payment is $1,347 per month.
B. 3.75% with 0 points and no closing fees. APR is 3.75% and total cost is zero. Payment is $1,389 per month.
Which is the better deal? Looking at APR it would seem that A is the better deal. However, although A is $42 per month lower in payment, is also costs $5,000. That means it takes 119 months for A to break even (compared to B), or the payment savings to match the cost of the loan. That is almost 10 years! So if you dont have the mortgage for 10 years, B is the better deal. And what is more, as compared to whatever your original rate and payment is B saves you money starting month 1, so even if you sell your home 1 year from now, you still saved 12 mortgage payments at the lower rate. If you refinanced with A, paid the $5,000, and then sold your home 1 year from now you may actually lose money on the refinance.