The Mortgage APR Game

Don’t be Fooled by the Lowest APR When Shopping for a Mortgage

So, you are looking for the best rate on a mortgage? Isn’t the mortgage with the lowest Annual Percentage Rate (APR) the best deal?

Not so fast. If only it were that easy.

Federal Law requires that APR be disclosed alongside the actual interest an attempt to help you make a more informed choice. The truth is that APR is a poor way to comparison shop for a mortgage and can lead you to make a costly mistake.

Stick with me on this explanation. This will save you a lot of money.

APR was created in order to provide a way for you to account for costs associated with a mortgage. This is a great idea because it is not easy to choose between a loan with a lower rate and higher fees or a loan with a higher rate and lower fees.

The problem is that the APR calculation makes some very bad assumptions.

First, APR assumes zero inflation and that the value or buying power of a dollar today will be exactly equal to the value of a dollar in 10, 20 or even 30 years from now.

Second, the APR calculation assumes that the mortgage will never be prepaid or paid off. That means no refinancing or selling the home...highly unlikely since the average life of a home mortgage in Virginia is about seven years.

Third, the APR calculation does not consider the value of the money used for fees. So, if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it were not spent on closing costs.

And finally, APR does not take tax consequences into consideration. This can be significant since higher fees on the mortgage may not be deductible while the higher interest rate typically is deductible.

Moreover, APR can be manipulated – more about that later.

Warning: Some math is involved. Keep reading. It will be worth it.

Here is a real example:

Option 1 Option 2
$100,000 Mortgage $100,000 Mortgage
Rate: 4.25% on 30 Year Fixed Rate: 3.75% on 30 Year Fixed
Zero Points: $0 2 Points: $2,000
Lender Closing Costs: $800 Lender Closing Costs: $800
Interim Interest: $300 Interim Interest: $300
Monthly Payment (P&I): $492 Monthly Payment (P&I): $463
Amount Financed: $98,900 Amount Financed: $96,900
APR: 4.35% APR: 4.01%

In both options above, the loan amount is $100,000, but the borrower is paying fees and interim interest in order to obtain the loan. The loan amount minus points, lender costs, and interim interest = Amount Financed.

For Option 1, the calculation would look like this:
$100,000 (Loan) minus $800 (Lender Fees), minus $300 (Interim Interest) = $98,900 (Amount Financed)

For Option 2, the calculation would look like this:
$100,000 (Loan) minus $800 (Lender Fees), minus $2,000 (Points), minus $300 (Interim Interest) = $96,900 (Amount Financed)

Once the Amount Financed is established, we use the monthly payment on the loan as a function of Amount Financed to establish APR.
Option 1 Example:
The $492 monthly payment on the above $100,000 mortgage corresponds to a 4.25% rate on a 30-year fixed.

But the $492 monthly payment on the $98,900 Amount Financed corresponds to a rate of 4.35%...this is the APR.

The Option 2 APR is 4.01% using the same calculation.

So Which Option is Better?

Based upon APR, it appears Option 2 is the better choice because the APR is much lower. But is it really?

Option 2 does save you $29/month, but costs $2,000 more upfront.

A simple calculation of taking the cost of $2,000, divided by the savings of $29/month, results in a breakeven period of roughly 6 years.

A more accurate comparison would take the upfront value of the $2,000 into consideration. This can be done by taking the dollars that would have been used for the upfront cost and reducing the amount borrowed by that same amount. This would bring the difference in cost to about $19/month and result in a real breakeven timeframe of roughly 9 years.

Therefore, Option 2 would only provide a real savings for you after 9 years, even though the APR is lower. And the chance of that you will remain in the same home, with the same mortgage for that long of a time period is very slim.

Option 1 is the better option for the first 9 years and would likely result in the best choice for you since the majority of people will have moved or refinanced within the 9-year period. While the APR for Option 2 is lower, the real world tells us that Option 1 will provide you with the lowest cost for the time you are going to keep the mortgage in place.

Now here is where it gets interesting.

The Amount Financed can be manipulated by assuming a closing on the last day instead of the first day of the month. That would increase the Amount Financed and decrease the APR even though the real costs of the loan did not change.

The bottom line is that APR is a flawed and inaccurate way to compare loans.

Our Borrow Smart Planning tools are the easiest way for you to compare interest rates, costs, programs, down payments and other options to design the lowest cost financing for your home.

Ask for your free Borrow Smart Plan today.