Why APR is not the best tool for comparing loans

Minneapolis, MN: I see it all the time. Arm chair financial guru’s always claim that using APR annual percentage rate is the best way to shop for a mortgage loan. While in theory, that is correct, in practice, it could end up giving you the wrong home loan.

The Federal Government requires APR to be disclosed right along side the loans interest rate as a means to help borrowers make an informed loan decision. Everyone understands the interest rate. Lower rates equal better deals and lower payments, but few people understand APR.APR Annual percentage rate

The APR takes the base interest rate, then factors in all of the following, and more; lender fees, discount points, days of interest, points to buy down the rate, and mortgage insurance (if applicable). If two lender quote you the exact same interest rate, the lender with the lower APR is supposed to be a better deal because of less costs and fees. So in theory, the lender quoting you the lower APR is always the better deal, right?

Wrong. The truth is that APR is a very poor way to comparison shop for a mortgage, because it can cause borrowers to make costly bad decisions.

APR was created to provide a way for borrowers to account for closing costs associated with the getting a mortgage loan. This sounds good in theory because it can be very confusing for home buyers to compare loans.

APR calculations are based on bad assumptions.

The first issue is 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 10-years,  20-years, or even 30-years from now.

Next, the APR calculation assumes that the mortgage loan will never be pre-paid or paid off early. That means no refinancing or selling the home. This is highly unlikely since the average life of a home mortgage loan is less than seven years.

Just think about your own loans: Is it rare to see the same loan in place for the full term of the loan. You only get the actual APR listed if you carry a loan fully to term.

Mortgage interest is front end loaded, meaning you pay more interest than principal in the beginning years of a loan, while towards the end of the loan, you pay more in principal than interest. So assume you got a APR quote of 4.21%. Your actual APR would only be 4.21% is you carried that loan for the full 30-years, and never pre-paid a dime.  If you sold the home after a much shorter time, your actual effective “APR” could be 15%, or even higher.

The APR calculation also does not consider the time value of the money. So if you spent a few thousand dollars buying down the interest rate with discount points, APR calculation does not give any value to the money if it wasn’t spent on closing costs.

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

Finally, APR can also still be easily manipulated by bad lenders, making it totally worthless for real life comparisons. 

Real World APR Considerations.

I spoke earlier of two lenders giving you the same rate, and comparing APR. But what if two lenders give you different interest rates? Now comparing loans with the APR calculation is totally confusing. The lower rate will always have a lower APR, but what did it take to get the lower rate?

Let us assume a $150,000 loan. Lender A is offering a great low rate of 4.250 percent and $3000 more in points Lender B, who is offering a higher rate of 4.625 percent, but with no points. Which one is better?

The payment difference between the two interest rates is just $34 per month. So is it worth paying $3,000 in points to Lender A in order to save $34 per month? Maybe. Maybe not.

In this example, it will take a little over 7-years to break even on the additional up-front closing costs. If you are going to be in the home less than 7-years, this is a POOR loan choice. You paid more up-front than you ever saved, but you got a lower APR.  If you are going to be in the home 20-years, paying the higher cost for the lower interest rate is a great choice.  You save more in interest than it cost up front.

Many mortgage companies these days quote no origination fee loans. These lower closing costs sound great, but but they don’t really have lower closing costs, and they sure as heck are not working for free. To give you those lower closing costs, they simply INCREASE the interest rate they offer.

There is also the opposite, this is called discount points, where you pay more money up-=front today in exchange for a lower interest rates.

But wait, to make the decision even more complicated (if that’s possible), borrowers rarely take the value of to day’s dollars and cash flow into account. If you are going to be in the home 20+ year, but you don’t really have the additional $3,000 costs, now what?

How about the other direction again. Maybe you know you’ll likely be in the home 20 plus years, but you don’t really have the extra $3000, or don’t want to spend the extra money today to get the lower rate.

Worse yet is on a refinance loan, where they tease you with super low rates, but you end up financing the discount points into the loan itself… Yikes.

APR annual percentage rate

The bottom line is that you should forget APR annual percentage rate by itself to pick a loan. Instead, do simple math in conjunction with an analysis of the cost benefit of lower rate/higher costs, or higher rate/lower costs as it pertains to your individual situation and cash flow.

Any skilled professional Loan Officer can assist you with all of these calculations. We lend in MN, WI, and SD.


How to get the best interest rates or closing costs

How to get the best interest rates or closing costs probably isn’t what you think.
Minneapolis, MN: Buying or refinancing a home? What mortgage company should you work with? What lender offers the best interest rate? Sadly, so much of what you see out there is simple advertising smoke and mirrors designed to capture your attention. 
For example, did you realize you can pretty much pick any interest rate or closing costs you want on your mortgage loan?

HOW THE BEST INTEREST RATES WORK

Want a super low interest rate? No problem.  best interest rates

In many cases, you have the option to pay more money upfront in exchange for a lower rate.  Some refer to this as “paying points,” buts that’s a bit of an archaic term.  Self-annointed gurus used to say “never pay points!” But that’s not necessarily good advice.  Discount (or “discount points”) offers a perfectly legitimate and objective choice to pay more money upfront in exchange for a lower interest rate.   Whether or not the trade-off makes sense to you is fairly subjective.  

In the more intelligent conversations, discount is discussed in terms of “breaking even” or “break even months.”  In other words, if I pay extra cash today, how long will it take for me to break even due to lower monthly payments.  Closer to 10 years?  That doesn’t make sense for most people.  5 year or less, however, and it can start to make better sense.  

All this to say that the discount points required to move down to 1/8% are fairly low for most lenders at the moment.  For instance, paying an extra .5% of the loan amount could get you another eighth of a point lower interest rate, and it would take just over 4 years to break even on that extra expense.  Of course, if you plan to sell or refinance in 3-5 years, this makes no sense. If this is the last house and mortgage you want for the foreseeable future, it’s something to consider.  

Lowest closing costs

HOW THE LOWEST CLOSING COSTS WORK

A similar conversation can be had for paying less in closing costs up-front today. You can choose to pay lower closing costs today, but understand this is simply achieved by the lender raising the interest rate you would get.  Small reduction in costs equal small rate increases, while large reduction in closing costs equal large interest rate increases.

This trade off is know as ‘Lender Credits’

So again, what is the math, and does it make sense? A common lower closing cost quote is a “No Loan Origination” quote. On most fixed-rate loans, you can eliminate loan origination costs, which is 1% of the loan amount by roughly increasing the interest rate 1/4%.

On a $200,000 loan, eliminating loan origination would save you $2,000 today, but a 1/4% higher interest rate will cost you $29 more per month on that $200,000 loan. Simple math gives you a 69 month break even period. If you are in the loan less than 69 months, you win.  Each month after 69, you pay an additional $29.

What is the math calculation on your loan amount?

But wait, even this is too simple. Do you have the money today? Do you want to keep some of that money in your pocket today to use for something else? So again,  Whether or not the trade-off makes sense to you is fairly subjective. 

Lower closing costs in exchange for higher interest rates is also a perfectly legitimate tool for home owners.

THE BOTTOM LINE

Don’t fall for advertising gimmicks. Rates way lower than everyone else, you are buying discount points, but may not know it. Anyone offering ‘no lender fees’, rebates, or any other sort of reduced closing costs are simply increasing the interest rate to pay for it.

The bottom line is simply this. A good conversation with a licensed, experienced, professional Loan Officer over your long-term, short-term, payment and equity objectives, is the only way to determine what is best interest rate for you and your situation.