Using APR to find a “great deal”

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Last year I blogged about whether or not APR really showed the “truth in lending.” You can see that post from my blog here. Recently I ran across a post by Dan Green from @mortgagereports. Dan is a loan officer in Ohio, and had some great points about APR. Here are some of the highlights of his detailed post (for the entire post, go here). Take it away Dan…

It’s a myth that you can shop for a mortgages using Annual Percentage Rate (APR) calculations. No matter what your loan type — FHA, conventional loans, VA, USDA or jumbo — APR is among the most easily manipulated numbers in the mortgage business and some lenders count on you not knowing that.

APR is a government-created math formula. It’s meant to measure the “true cost” of a loan, from the date of closing to the date of payoff. APR is roughly measured by taking the original loan size, accounting for closing costs and prepaid items, then estimating how much will have to be paid over 30 years to pay off the loan in full. APR answers the question, “If I borrow this much money, and it costs me this much to pay off my loan, what would my theoretical mortgage rate have been?

By showing APR along with every rate quote, it’s believed that customers will be better informed and can make better loan choices. In some cases, this is true. In many cases, it is not. APR is not the apples-to-apples comparison tool it’s advertised to be. This is because the loan with the lowest APR isn’t always the loan that’s best for you.

Banks and lenders love to promote their “low APR loans” — especially online. Unfortunately, getting a low APR doesn’t translate to getting a “great deal”. This is because the APR formula is flawed.

Calculating for APR requires a lender to makes serious assumptions about the future and, as we all know, predicting the future is impossible. For example:

  1. The APR formula assumes that you will hold your loan for 30 years
  2. The APR formula assumes that you will never make extra principal payments of even $1
  3. The APR formula assumes that you will not refinance or sell your home
  4. The APR formula uses third-party loan costs (appraisal, attorney fee, title search, etc) which are sometimes unknown. These fees are estimated, which means the APR is estimated and can appear artificially low.
  5. The APR formula struggles with adjustable-rate mortgages because it makes assumptions about how the loan will adjust during its complete, 30-year term. Will mortgage rates rise over 30 years? Will they fall? By how much will they rise or fall? Two lenders using two different set of assumptions will publish two different APRs — even if the loans are identical in every other way.

If any of these statements are “untrue”, or have the chance of being untrue, APR fails as an apples-to-apples comparison tool. This is a huge deal when comparing loans with discount points to loans without discount points.

For example, as compared to a loan with no discount points, a loan with discount points will have higher closing costs but lower principal + interest payments each month. Over the life of the loan, the lower payments will render the loan with discount points “cheaper” and so it will have a lower APR than the low-fee mortgage choice. If you chose your loan strictly by APR, you would end up choosing the loan with the highest closing costs and the best long-term payoff.

Don’t get me wrong, this is fine if you plan to stay in your home for 30 years and never make extra payments on your loan. However, if you plan to sell in fewer than 30 years or make extra payments, the APR comparison weakens. In this case, buying by APR isn’t the best way to shop — you’ll front-load your mortgage with fees.

The important thing to remember is that APR is not the metric for comparing mortgages — it’s merely a metric. The better way to compare two mortgage rate offers is to look at the mortgage rates as compared to the fees…

Thank you for the great insight Dan. I couldn’t have said it better myself!

If you’ve been shopping by APR, and would like to have a fresh look comparing rate and closing costs, feel free to contact me to get started. If you are buying in the state of Georgia, I can help!

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