What is APR? How does APR work?

Lenders are required by law to show you not just the loans rate, but a loans APR

Minneapolis, MN: A borrower shopping for the best mortgage rate can easily be seduced by low rate offers that are accompanied by low annual percentage rates (APR). Federal law requires that APR be disclosed along side the actual interest rate as a means to help borrowers make a more informed decision on their mortgage.

In theory, APR would seem to be a valuable item, as APR basically just takes the base interest rate they quote you, calculates closing costs, and mortgage insurance if applicable, and gives you a new interest rate, known as the effective rate, or APR.

In theory, the the lower the number, the better the deal, and the lender is charging less costs. In practice, the math is much more complicated, and the comparison can be very misleading. If two lender quote you the exact same (base) rate, then the lender with the lower APR is supposed to be a better deal. If the lenders are playing fair, this works well in giving you accurate information. 

The second you change the base rate, APR becomes a worthless.

The truth is that APR is a very poor way to comparison shop for a mortgage and can cause borrowers to make costly 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 may not be very easy to choose between a loan with a lower rate and higher fees, or a loan at a higher interest rate with low fees.

If two lenders are quoting different interest rates, then easily comparing the loans with the APR calculation is totally out the window and potentially very misleading.

Furthermore, the APR calculation only keeps the monthly payment information the same. Instead of the mortgage amount, APR uses "amount financed." This is the "amount financed" information on a typical Truth in Lending statement. Amount financed takes into consideration the fees that are lender imposed, such as application fees, discount points, commitment fees, and interim or per diem interest.

So, amount financed is the mortgage amount less any lender fees, points, and interim interest. The more fees, the lower the amount financed. The monthly payment is then calculated as a product of the amount financed to give you the annual percentage rate or APR. So, the lower the amount financed, the higher the APR is.

Amount financed can be manipulated. A common way is by a quoting a closing on the last day of the month, instead of the first day of the month. That would decrease costs on paper, increase the amount financed and decrease the APR.

Shopping For A Loan With APR

Another big problem is that the APR calculation is based on 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 10, 20, or even 30-years from now.

Next, the APR calculation assumes that the mortgage will never be pre-paid or paid. 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 even just five years for many people.

The APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in discount points or higher closing cost fees to get a lower rate, the APR calculation does not give any value to the money if it wasn't spent on closing costs and used elsewhere.  Plus, do you even have the additional money to spend?  Is it more important to have a lower rate today, or keep that cash in your pocket today?

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 be easily manipulated by bad lenders, making it totally worthless for real life comparisons.

Sample APR Math

Here is a real example on a $400,000 fixed rate 30-year mortgage with no mortgage insurance:

1. Lender A is offering a great low rate of 6.00%, $5000 in closing costs, plus two discount points.
2. Lender B is offering a higher rate of 6.50%, $5000 in closing costs, and no points.
3. Lender C is offering a rate of 7.00%, and zero closing costs

 A quick look, and you think option one, with a rate of 6.00% is best, but now lets look at the finer details.

• Option 1 has an APR of 6.257%, closing costs of $5,000, plus $4,000 is discount points ($9,000).  Monthly payment is $2,398.
• Option 2 has an APR of 6.57% closing costs of $5,000. Monthly payment is $2528
• Option 3 has an APR of 7.002%, closing costs are zero, Monthly payment is $2,661

While option 1 has a lower payment by $130 per month than Option 2, you had to pay $4,000 more in costs to get that 'better rate'.  Divide $4,000 additional cost by $130 a month savings, and it will take you 31 payments just to break even on the higher upfront costs.

Option 3 has the highest payment, but you didn't need any money for closing costs or discount points.

If you plan on being in the loan a long time, the math gets better and better over time for the lower rates. But what if you move or refinance.  Good chance you paid all the extra upfront money, and may not have even been in the loan long enough to reap much, if any benefits.

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 $4,000 costs, now what? How about if you had zero extra money for closing costs and discount points?

These calculations also assume you are paying the costs out-of-pocket today. But what if you roll the added costs into the loan?  Then the payback times increases, potentially a lot, taking away a lot of the value of the lower rate.

Assume now the loan is a refinance, and you still owe $400,000. Almost no one pays closing costs upfront.  Rather, they roll the closing costs into the new loan.  Using this math, the new loan is now $400,000, $405,000 and $409,000.

The Bottom Line

In theory, APR would seem to be a very valuable shopping tool.  In practice, you are much better off speaking with one of our licensed and experienced Loan Officer to discuss your overall situation to determine what loan, rate, and cost option works out best for you.

The bottom line is that you should forget APR and think twice about those advertised low rates when they are accompanied by higher fees.

Call us at (651) 552-3681, or start an online loan application here.