If you, like so many people these days, are in the market for a new home, you’ve probably heard the phrase “Low APR!” and determined that the lender promoting it might be a good choice for your mortgage lending needs.
Once you fully understand how APR, or annual percentage rate, is calculated, however, you’ll know not to take the bait. In fact, you’ll know why you should never select a lender based on the APR that it’s featuring.
What Is APR?
APR, part of the federal government’s Truth-In-Lending Act, is meant to reflect the “true cost” of your loan, from the moment it’s signed until it’s paid in full. The interest rate you pay on a loan is just a starting point in determining what you’ll pay for the loan; add in the various fees charged to process the loan and you’ve got your annual percentage rate.
To calculate APR, the fees are “rolled into” the interest rate by amortizing the total fees out over the life of the loan. The idea behind APR is to help borrowers understand the true costs associated with their loan program, how much is paid upfront – can have on the final cost of a loan.
Unfortunately, though, many people are lured by the “low APR” jargon and don’t realize that comparing lenders based on APR is not always practical.
Here’s an example:
- You’re in the market for a 30-year fixed mortgage on a $200,000 loan
- Bank A’s interest rate is 5% with $3,000 in fees to be paid upfront; the APR is 5.13%
- Bank B’s interest rate is lower, at 4.85%, with $6,000 in fees being paid upfront; the APR is also lower, at 5.11%
- If you don’t plan on being in that house 30 years, Bank B’s mortgage might not be the right choice, however. If you need to sell that house in 3 years, for instance, the loan from Bank A, with a higher interest rate, is a better choice because you paid only $3,000 upfront, not the $6,000 to Bank B in exchange for the lower interest rate
Why APR Is Flawed
No matter what type of loan you’re going after (VA, FHA, conventional, etc.) you should not make a decision on a lender by comparing APR. That’s because an APR rate can only be calculated if a number of assumptions are made – assumptions that are probably incorrect:
- If you see a published APR, the lender has made the assumption that this is a 30-year loan, that you’ll never make an extra principal payment, and that you’ll never refinance or sell the home. APR spreads the fees paid upfront over the life of the loan (in this case 30 years), so comparing APRs is only accurate if you plan to keep the mortgage for the entire length of the loan. Since most borrows don’t, the APR can make some loans look artificially better
- In addition, for loans that include fees for mortgage insurance, APR assumes a specific date upon which that insurance is no longer being charged. This is nearly impossible to do with accuracy
- Also, if you’re comparing loans with points to a loan without points, a loan with points will often boast a lower APR, even thought the loan may not be cheaper
When shopping for a loan, shop first based on interest rate, then compare the fees at that rate – compare apples to apples, in other words. If you simply compare banks’ APRs to find a lender, you may be making a decision that isn’t in your best interests. Another good tip? Talk first to a banker you can trust to provide practical advice – like one of FNB Fox Valley’s bankers! Our mortgage team will be happy to discuss options and “run the numbers” with you – give us a call at 920-729-6901.