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Everyone in the market for a mortgage loan thinks comparing the Annual Percentage Rate (APR) from competing mortgage companies is the way to choose the best loan.
And it’s all wrong.
At best, trying to understand what APR means and using it to find the best loan adds unnecessary confusion to the process of finding the right lender. And in the worse case, it gives you incorrect information.
Here’s a simple explanation of what APR is, why it exists, and why it may not be helpful in choosing your mortgage.
The Annual Percentage Rate
First – let’s talk about why it exists. The Federal government wanted to find a way to protect consumers and let them know that a loan costs money beyond its’ interest rate. They wanted it to be clear there are additional fees that must be paid to get a loan. So they required all lenders to disclose in writing, side by side, the interest rate quoted and the APR for that loan.
The problem is consumers don’t know what the APR meant and why it was higher than the interest rate. They need to know what loan fees are included in calculating APR and how it’s calculated.
The loan fees that are used to calculate APR are:
- Points- both discount points and origination points. (1 point equals 1% of the loan amount.)
- Pre-paid interest – this is the interest paid, at the time the loan closes, from the date the loan funds to the end of the month. For example, if the loan funds on the 15th of the month, you will pay 16 days of pre-paid interest at closing.
- Lenders Admin Fee (if the lender charges this)
- Loan-processing fee (if the lender charges this)
- Underwriting fee (if the lender charges this)
- Document-preparation fee (if the lender charges this)
- Private mortgage insurance (if you will be paying this)
- Escrow/Settlement fee (a charge that has nothing to do with the lender, but is charged by and paid to the settlement agent)
- Loan-application fee (if the lender charges this)
We’ll talk about the many “if the lender charges this” comments in a moment, but first, let’s look at how these fees are part of the APR for a mortgage.
Just for calculating the APR, these loan fees and settlement fee are considered Pre-Paid interest instead of a fee. The total dollar amount of these fees is added to the total amount of actual interest paid for the loan. Once these two numbers are added together, you can calculate an interest rate based on the amount paid.
A critical point about the calculation is that it’s made based on the number of years the loan is amortized over – typically 30 or 15 years. But if you were to pay off (or refinance) your 30-year loan in 7 years, the APR you used to compare loans was not correct for your situation. It should have been calculated for seven years to give you a number that accurately reflected your costs.
And that’s not the only problem with relying on an APR to help you pick the best loan.
Take loan fees. All lenders are not the same when it comes to their loan fees. Or are they? You can see from the list above that there are many different potential loan fees, but not every lender charges every fee. It’s more common today for lenders to charge one all-encompassing loan fee called the Origination Fee. This fee is added into the APR calculation, along with assumed pre-paid interest and discount points, if the borrower chooses to buy down the interest rate.
However, lenders might lump third-party costs into their origination fee, such as appraisal fees, credit report fees, and tax validation fees. These are fees that wouldn’t usually be in the APR calculation, so if a lender includes them in one large fee – the APR for that loan will appear higher than the one for a loan that does not include third-party fees into the origination fee.
Another arbitrary change that will impact APR is estimating the date the loan is going to fund. Since all borrowers pay interest from the day the loan funds to the end of the month – estimating funding on the 10th day versus the 20th will make a difference in the APR calculation. But the day your loan is set to fund is not an additional cost of the loan (even though you can lower your upfront costs by closing later in the month.)
And if you’re planning on getting an adjustable rate mortgage(ARM), you’ll learn that the APR calculation for these loans is based on somewhat arbitrary assumptions that may or may not happen. For ARM loans, interest is calculated based on the highest (ceiling) rate the ARM is allowed to reach. So the maximum interest rate cap is driving the calculation of the APR instead of the extra costs of the loan.
- How lenders might combine lender fees and third-party fees.
- The actual time you keep the loan versus the amortization used to calculate the APR up front.
- The way APR is calculated for adjustable rate mortgages.
Illustrates some of the problems with using APR to compare your loan options.
It’s in the Details
The best way to compare loans is to take the actual “estimated” costs for the loan per lender. These will be available in a Loan Estimate (LE) for you, although they’ll be based on some ballpark assumptions such as loan amount, interest rate, and closing date. Take the LE’s you receive and note:
All lender fees
For lender fees, include any fee that is directly charged by the lender versus third-party fees, and confirm with the lender if any third-party fees are covered for you by their origination fee.
The estimated interest rate quoted is the other piece of data to capture in your spreadsheet and if you have opted to pay any fees to lower your interest rate (known as discount points.) By paying discount points, you are pre-paying interest upfront to reduce the rate for the life of your loan – and you do not have to do this to get a loan.
Once you have all of this data, you need to calculate how much it will cost you to get the loan, from each lender, for the length of time you estimate you’ll keep the loan. Here’s an example:
You plan on borrowing $600,000 for 30 years, although it’s fairly certain you’ll sell the home and pay off the mortgage in 8 years, and will not be paying any discount points. Lender A quotes 4.75% interest with an origination fee of $1500 (doesn’t cover third-party costs), while Lender B quotes 4.875% with fees of $500 (doesn’t include any third-party costs).
The total amount of interest and fees you’ll pay in eight years for Lender A is $229,500. For Lender B the total is $234,500. So even though you would save $1000 upfront, for Lender B, you will pay more in the time you have the loan.
You should also find out if the lender will be choosing the escrow/settlement agent or if that choice is yours, so you know if you need to comparison shop different settlement agents. Also, plan on closing your loan as late in the month as possible to minimize the pre-paid interest cost. If you’ll need to carry private mortgage insurance, request a quote from the lenders you talk to – and let them know what the other quotes are you’ve received.
This is the best way to compare loans – not the APR. Do your math to calculate how much your actual cost will be over the time you estimate you will have the loan to choose the best loan.