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With the Income You Need to Buy a Median-Priced Home rising, you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

With the Income You Need to Buy a Median-Priced Home rising, you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

Shopping for a Mortgage: What APR Can't Tell You

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APR, or annual percentage rate, represents the cost of your mortgage expressed as a single number. APR is supposed to make comparing and selecting the best mortgage rates easier, and mortgage lenders are required by law to disclose it.

What is APR?

The APR is a measure of the total cost of credit, expressed as a nominal yearly (annual) rate. It takes into account the loan's contract interest rate (the interest rate the borrower will be paying), incorporates many of the fees a borrower pays to obtain the loan, and expresses it as a single number. It can help make comparing loans with different rates and different fees a little simpler.

If you borrow $200,000 at 3%, you are paying more for your loan than just the 3% interest rate. For example, it might cost you $4,000 just to obtain the loan. Since it cost you $4,000, your actual proceeds from the lender is just $196,000, not the $200,000 on which you'll pay interest. In this way, the APR is a number that takes into account the effect of costs such as loan origination fees. Here's how the APR would be calculated given this example:

  • Your contract loan amount is $200,000 at 3% interest.
  • Your required Principal and Interest payment is $843.21; however,
  • You pay $4,000 in origination fees. so your net proceeds are only $196,000.
  • The monthly payment on $196,000 at 3% should be $826.34; but
  • You are required to pay $843.21 each month.
  • Working backwards, a $196,000 loan requiring a payment of $843.21 creates an interest rate of 3.159%, which is the loan's APR.

To easily make this APR calculation, use HSH.com's APR calculator. For example, if you need to borrow $200,000, and you have the choice of two 30-year mortgages -- one with a 3% interest rate at 2 points (costing $4,000), the other with a 3.25% interest rate and zero points, which is the better deal? The results from the APR calculator tells you that the APR for the first loan is 3.159% and for the second loan is 3.25%.

So you should go with the first loan, right? It's not that simple. Since your APR is not your only consideration, choosing a home loan is not quite the black and white process these numbers would suggest.

Mortgage Shopping: Limitations of APR

APR calculations assume that you are going to keep your mortgage for the entire 30 years, so upfront fees are amortized over that entire period. Breaking down fees over a long period dilutes their effect on the APR. However, the average homeowner only keeps a property for about seven years. If you only keep that first loan for seven years, your actual APR jumps to 3.582%; the APR for second choice remains at 3.25%, so the loan with the lowest APR may not be the best deal at all. In general, if you aren't certain that you're going to keep the property or your mortgage for more than a few years, and you are choosing between two loans with similar APRs, it's often best to select the one with the fewest upfront fees.

APRs to Compare Adjustable-Rate Mortgages

The APR is even less useful as a predictor of the true costs of a home loan if you are considering an ARM or hybrid ARM (loans with fixed rates for the first few years, then adjustable there after). APR calculations for ARMs come with several assumptions, and their flaws are very obvious. Aside from the influence of fees, the APR calculation is performed on the assumption that your interest rate is fixed at the start rate for the time period specified in your loan documents, then increases at its first scheduled adjustment to a fully-indexed rate based on a financial index, such as the T-Bill or LIBOR, plus a margin and remains there. Worse, it uses today's value for the index, when it's certain that the value when the loan actually adjusts will be different.

It is a technical flaw in the math used for calculating ARM APRs that could see your ARM's APR be less than the contract interest rate specified in your loan documents. As a result, APRs for ARMs can't always be trusted.

For example, if your loan was based on the LIBOR rate plus a margin of 2.75%, your fully indexed rate in early January 2022 would have been 3.35%. If your loan has a contract interest rate at 2.5% and was fixed for 5 years, your APR calculation would be based on the assumption that your rate is 2.5% for five years, then adjusts to 3.35% and remains at this rate for the final 25 years of your loan term (which of course it won't). This is obviously not accurate; a simple review of historical index values at HSH.com shows that LIBOR by itself has routinely run in the upper-2% to low 3% range in the five years prior to our example, so the loan's rate (and your APR) will certainly be different than what is stated at the outset.

In addition, some indexes are quite volatile and change from day to day. However, it may not be that meaningful to compare one lender's APR on Monday with another lender's APR on Friday, even if both involve the same index.

APR to Compare Different Loan Types

Finally, suppose that you are looking at two loans -- a 30-year fixed-rate mortgage at 3.5%, and a 5/1 hybrid ARM at 2.75%. The 30-year loan has an APR of 3.692%, and the hybrid ARM has an APR of 3.274%. Which is the better deal? You can't tell from an APR disclosure. APR can only be used to compare two loans of the same kind -- a 15-year fixed loan to another 15-year fixed loan, for example.

So, What Good Is APR?

Essentially, nothing, but it is the best tool we have at the moment. Aside from all the issues above, certain fees may or may not be included in the APR calculation, depending upon the lender's refund policy if the loan does or does not make it to closing. Because of this, two loans with identical fees and terms can have different APRs, making direct comparisons a challenge.

Most of the time, the loan with the lowest mortgage rate is also the loan with the highest fees. The APR can help you compare loans with different rates and fees to select the best one, but it is at best an imperfect tool. A better method might be for you to calculate your own actual APR, instead of the hypothetical one you see in advertisements. Use HSH.com's APR calculator to do the math.

If you know that you won't keep your loan for its full term, adjust the term in your mortgage calculator to make sure that you choose the best deal for you; the best deal for you may not be the loan with the lowest APR on your Loan Estimate disclosure form.

Shopping For Your Loan Matters To Your APR

Mortgage markets are competitive, and shopping around among lenders is the best way to find the lowest mortgage rate for your loan. Since the interest rate of the mortgage is the largest component of the APR, finding the lowest rate for your circumstance can be a good starting point for getting the lowest APR. When reviewing deals, consider both the rate and APR; lenders may offer the same rates but different fees, or have the same fees at different rates, so you'll need to consider both expressions when you are comparing mortgage offers.

This article was updated by Keith Gumbinger and Gina Pogol.

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