You’re shopping for mortgage rates and you want today’s absolute best deal. Don’t we all.
Finding that “deal”, though, won’t be easy as you’d think. There’s a lot of information to consider on a purchase mortgage or refinance, and most of it’s confusing.
This is why rate shoppers tend to use Annual Percentage Rate (APR) calculation to help with their comparisons. APR is supposed to represent the “true cost” of a mortgage over time. However, it doesn’t.
When you shop by APR, you may be less likely to choose “the best loan” for your needs. APR is among the most easily manipulated numbers in mortgages. Worse, many lenders count on you not knowing that.
APR is not the metric for comparing mortgages — it’s merely a metric.
What Is “APR”?
More commonly called APR, Annual Percentage Rate is a government-concocted math formula. It’s meant to measure the long-term cost of a loan, from the date of closing to the date of payoff.
APR is roughly measured by taking the original loan size, accounting for closing costs and prepaid items, then estimating how many dollars will have to be paid over the loan’s term to pay off the loan in full.
For a 30-year fixed rate mortgage, the loan’s term is 360 months. For a 15-year fixed rate mortgage, the loan’s term is 180 months. And so on.
APR attempts to answer the question, “If I borrow this much money, and it costs me this much to pay off my loan, what would my theoretical mortgage rate have been?”
APR is printed in the top-left corner of the Truth-In-Lending Disclosure, as shown above.
Loan officers are required to disclose a mortgage’s particular APR every time they make a rate quote. This is federal law, meant for consumer protection.
By showing APR alongside every rate mortgage quote, customers are purported to be empowered to make better, wiser home loan choices. And, in some cases, APR works.
In many more cases, though, APR fails — especially online. This is because APR can’t be the “apples-to-apples” comparison tool it’s advertised to be.
The loan with the lowest APR isn’t always your best loan.
APR Is Not An “Apples-To-Apples” Comparison Tool
Banks and lenders love to promote their “low APR loans” — especially online. In fact, by default, most online mortgage marketplaces sort their quotes by APR.
This means that the loans with the lowest APR show up first, follow by loans with higher APR. This can be misleading. Getting a low APR doesn’t mean you’re getting a good deal.
The APR formula is flawed. Here’s why.
When your lender calculates an APR, it’s estimating your long-term cost on your loan. In order to make that estimate, the lender has to predict the future, while making drastic assumptions about what may or may not happen.
Here are three such assumptions :
- The APR formula assumes that you will hold your loan for 30 years
- The APR formula assumes that you will never make an extra principal payment
- The APR formula assumes that you will never refinance or sell your home
And, for loans with private mortgage insurance (PMI), the APR formula makes an assumption for the specific month-and-year that your home will reach twenty percent equity; that your PMI will go away.
This is impossible and it’s for these reasons that Annual Percentage Rate fails.
As another example, consider two loans — one with discount points and one without.
When comparing loans with discount points to loans without discount points, loans with discount points will nearly always show a lower APR even though the loan may not be “cheaper”. Loans with discount points are front-loaded with fees and can be a terrible choice for somebody living in a home for less than ten years.
Online lenders know this, but don’t care. Requiring big discount points make their “deals” look great online but, in reality, the loans are expensive.
Shopping by APR can be the worst way to shop for a loan.
APR Assumes You’ll Never Sell, Never Refinance
Your loan’s APR is affected by more than just discount points — loan fees play a role, too.
Remember that at the start of the mortgage shopping process, when you ask a lender for your APR, many of your final loan costs are still unknown. Third-party loan costs such as appraisal and title services are estimated, and so are some lender fees.
This is why your receive something called a Good Faith Estimate. There’s a reason it’s not called the Good Faith Iron-Clad Guarantee. At the start of the loan process, banks don’t know each fee you’ll pay to the penny.
Meanwhile, these costs figure into your APR so when a banks estimate fees, APR becomes an estimate, too.
Another APR flaw is linked to adjustable-rate mortgages (ARMs).
The government’s APR formula requires banks to assume how your loan will adjust over its 30-year term. These adjustments affect your estimated future payments which, in turn, affect your APR.
Despite equal mortgage rates and fees, then, a bank which assumes the smallest mortgage rate adjustments will also show the smallest APR. The loan may not be “better” — it just makes rosier predictions about the future.
This, too, is misdirecting.
Compares Apples Or Oranges, But Not Both
APR can muddy the process of shopping for a mortgage rate. Rather than shop by APR, consider picking a specific rate you want, then shopping for fees at that rate. Or, choose a zero-closing cost mortgage and shop for rates at that zero-fee.
In other words, fix one piece of the puzzle in place, then shop for the other because you can’t shop for both at the same time.
As a real-life example, if today’s 30-year fixed rate mortgage rate is 3.50% and your quotes from three separate lenders require fees of $1,500, $2,000, and $3,000, it’s clear which option is going to be best — the option with the fewest closing costs.
This is far simpler than trying to compare 3.50% at $3,000 versus 3.625% at $500 versus 3.75% with no closing costs. Especially because the 3.50% rate may show the lowest APR.
As an another example, if you ask all three lenders for a zero-closing cost mortgage rate at the rates come back at 3.625%, 3.75%, and 3.875%, you’ll know exactly which one to choose, too.
You can’t shop for rates and fees at the same time and be sure you’re making a good choice.