Mortgage Rates and APR: Sometimes Low Is High

Posted by  on Apr 20, 2010

APR, or annual percentage rate, is another way of looking at the cost of your mortgage. Instead of saying, "This $400,000 mortgage comes with a rate of 5% and costs $8,000 to get," you could say, "This loan has an APR of 5.178%." How is that calculated?

  • The $8,000 in fees and points is added to the loan amount, giving a total of $408,000, which is what you're effectively borrowing.
  • The monthly payment on $408,000 at 5% is $2,190.
  • Working backwards to see what the interest rate is for a loan amount of $400,000 and a payment of $2,190, you get an interest rate of 5.178%.

To make this APR calculation easily, just use a mortgage calculator. For example, if you need to borrow $400,000, and you have the choice of two 30-year mortgages--one with a 5% interest rate and costing 2 points ($8,000), the other with a 5.25% interest rate and costing nothing, which is the better deal? The APR calculator's output is an APR of 5.178% for the first loan and 5.25% for the second loan.

So the first loan is the best deal, right? Maybe not.

Getting the Best Mortgage Rate: APR Doesn't Tell You Everything

APR calculations operate on the assumption that you keep your loan and pay if off over its entire term, so fees charged upfront are amortized over 30 years. However, according to the National Association of Realtors, average homeowners keep houses for about 7 years. If you were to keep the first loan for 7 years, its APR jumps to 5.610%, and the loan with no costs now offers the best mortgage rate.

APRs for ARMs

APR calculations for adjustable rate mortgages are also plagued with unrealistic assumptions. First, it's assumed that once your starting rate expires, your rate resets to its fully-indexed rate--and stays there for the life of the loan.

Here's an example: A LIBOR ARM has a margin of 3.00%, and its fully-indexed rate in January 2010 would have been 3.43%. If it has a start rate of 4% and is fixed for the first three years, the APR calculation is based on the assumption that the interest rate adjusts to 3.43% and stays there for the next 27 years. That would be nice! But historically, the LIBOR has risen as high as 9%. So you'd have a 12% loan, and that's not reflected in the APR.

APR and Mortgage Quotes for Different Loans

Finally, if you compare two loans--a 30-year fixed-rate mortgage with an APR of 5.5%, and a 3/1 hybrid ARM at 4.5%--which is the better deal? You can't tell from an APR disclosure. APR can only be used to compare the same kind of loans.

APR can help you compare mortgage quotes with different costs and rates. But look at your own situation and check out the upfront fees. The lowest mortgage rate for you may not be the loan with the lowest APR.


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