I'm comparing mortgage quotes and my real estate agent told me to choose the mortgage with the lowest APR (annual percentage rate) instead of just looking at mortgage rates. Is the lowest APR always the best mortgage rate?
Sometimes the lowest APR is not the best mortgage rate. To understand this, you need to know that APR was designed as a way for shoppers to compare loans with different pricing and determine which is the better deal.
For example, can you tell if it's better to choose a loan at 5.25 percent and zero fees, 5.1 percent and one point or a loan at 4.875 percent and two points? Converting the percentages to an APR, which incorporates the cost of the financing into the interest rate, helps you do this. In fact, lenders are required by law to disclose the APR to you in writing.
Try it yourself using an APR calculator. If you run these figures using any loan amount and a 30-year term, you'll see that the APRs are 5.25 percent for zero fees, 5.19 percent for one point and 5.05 percent for two points. The loan costing 2 points is the best deal.
APR is flawed
But here is one of several flaws of the APR calculation. The calculation is based on the assumption that you will keep that mortgage for its full term of 30 years. How often do you think that happens? If you keep the loan for 15 years, the APRs change to 5.25 percent, 5.25 percent, and 5.18 percent.
It gets better. If you refinance your mortgage or sell your home in 5 years (as many people do to accommodate growing families, take a job in another part of the country or downsize), your APRs change again to 5.25 percent, 5.51 percent and 5.69 percent!
The bottom line is that the more fees you pay upfront, the longer you need to keep your mortgage to make it worth doing. If your expected tenure in your home is short or unknown, choose the best mortgage rate at zero fees to save the most money.