APR: Can you Use it to Compare Mortgage Offers?
Looking for the best mortgage rate? Confused? Well, you are not alone. Mortgage loans come with a wide variety of terms and fees that are hard to understand, even before you have to read and try to understand all the mortgage paperwork. Even if you are comparing two mortgage offers side-by-side, it can be very confusing.
Mortgage rates are at historical lows. However, comparing loan offers is as confusing as ever. Interest rates for a 30-year mortgage have dipped below 3.5%, and below 2.75% for a 15-year mortgage. But when you’re trying to find the best mortgage deal you can, it’s important to pay attention to more than the nominal interest rate advertised.
When you look at a mortgage offer, you will see both a nominal interest rate and the APR (Annual Percentage Rate). All lenders are required by law to disclose the APR. The APR is supposed to be a simple tool to help you compare offers, because the APR includes the costs of the loan along with the interest rate.
Theoretically, you don’t have to compare nominal interest rates, only the APR. Unfortunately, it isn’t that simple, for a number of reasons, including the:
- Large amount of loan fees
- Different types of loans (fixed rate vs. variable rate)
- Amount of time you actually hold on to the loan.
To help you compare mortgage offers, interest rates and APRs, learn about:
- Understanding APR: Nominal rates, APR, and adding costs
- Mortgage Fees: What’s included in an APR?
- The length of the loan: APR and how long you hold on to the Loan
- APR – A partial tool to compare loans
Understanding APR: Nominal Rates and APR
Whenever you take a loan, you pay the lender interest. The amount you pay depends on the annual interest rate. For example if you take a $100,000 loan at 4%, then your interest payment is $4,000 per year. The nominal interest rate assumes that you are making one annual payment.
Compounded interest: If you make payments more frequently than once a year, then your actual interest rate increases. Mortgage loans usually have monthly payments. That means that your 4% interest rate is more than the nominal 4%, actually an effective rate of 4.074%. Note: Compounded interest is not always expressed in the APR.
The main reason that APR is used is to help you compare different loan offers that include fees. The APR calculates the interest rate based on the actual money you receive from the loan, namely the loan amount less the upfront fees you pay to get the loan. For example, if you take a $100,000 loan at 4% interest with no fees, your costs are different than if you take the same loan at the same rate but pay $1,000 in loan fees. In order to compare different offers, lenders are required to quote an APR that includes upfront fees.
Adding Costs: When you take out a mortgage loan, you might pay upfront fees to get the loan. One common fee is an origination fee, quoted to you as points. One point is one percent of the loan. If you take a $250,000 loan at 4% with a fee of 1 point, then you will pay a $2,500 fee. That means you are really borrowing only $247,500, but still paying 4% interest. Obviously the fee makes the loan more expensive than a similar loan that has no fee. In order to compare the costs, the APR bases your 4% interest rate on the net loan you receive.
In order to compute the APR, you need to consider the length of the loan. Remember, if there are no fees the APR will always remain the same, no matter the length of the loan. Here are a few examples for a $250,000, that all assume that you do not pay off the loan early (you make regular monthly payments for the entire life of the loan). The nominal interest rate is 4%:
|Length of Loan||Fees||APR effective||APR nominal|
So, when comparing a loan it is not enough to just look at the interest rate, which was 4% for all the above example, but you need to combine the interest rate, the fees and the length of the loan.
Mortgage Fees: What to Include in an APR?
Anyone who has shopped for a mortgage loan knows how complicated it is to compare loan offers. Mortgage loans come with a variety of mortgage rates and mortgage fees. The Consumer Financial Protection Bureau (CFPB) published a sample disclosure letter, including this breakdown of different fees:
- Lender Fees: Lenders quote their fees in fixed amounts and/or points (percentage of loan). Common fees include application, origination, discount, and underwriting fees.
- Other Fees: Mortgage loans include many fees that relate to your property, many that are paid to a party other than your lender, called 3rd-party fees . Here is a partial list of fees:
- Fees you can’t shop around for: Appraisal, Credit Report, Flood Determination, Flood Monitoring, Tax Monitoring, Tax Status Research
- Fees that can shop for: Pest Inspection, Survey, Title-Insurance Binder, Title-Search, Tittle-Settlement Agent
- Other costs: Taxes and other Government Fees
- Prepaid costs: Homeowners Insurance premium, Mortgage Insurance premium, Prepaid interest, Property Taxes
- Initial Escrow Payment at closing
Mortgage Insurance: One other important fee that you should include in your APR calculation is the cost of mortgage insurance payments. If you take a conventional loan with an LTV over 80%, your lender will generally require you to take out mortgage insurance. The lender automatically terminates the mortgage insurance policy when your LTV reaches 78%, based on your loan’s original amortization schedule. You should factor into your APR any required mortgage insurance payments. For most conventional loans, the APR quote you receive will not include mortgage insurance costs.
Most FHA loans have mandatory mortgage insurance. The FHA comes with high upfront MIP (mortgage insurance premium) as well as monthly MIP payments, which have increased during mid-2012. Lenders do include the FHA MIP in their APR calculations, because some type of mortgage insurance is mandatory for FHA loans.
There is no uniform position regarding the fees that should be included in the APR. Currently, lenders are required to include their fees, including application fees, underwriting fees, origination points and discount points, but not mortgage insurance. Although other fees are part of taking a mortgage, and you should shop around for those products whenever possible, I recommend that you compare your mortgage offers based on the total financial cost of your loan. You’ll get the most accurate estimate of your total costs, when you include every cost you’ll bear, but it makes the process complicated and cumbersome.
To help you understand the effect of fees on the APR, the table below shows a comparison of APRs for different 30-year mortgage loans, with nominal interest rate at 4%.
|Origination and Discount Points||Other fees||Loan Amount||APR effective||APR nominal|
APR: The Amount of Time You Hold on to Your Loan
The APR calculation assumes that you hold on to the loan for the entire length of the loan. That is a false assumption in the vast majority of cases. Most borrowers pay off their loans loan early, by refinancing into a new loan or by selling the home and paying off the remaining balance. Adding in the factor of how long you expect to hold onto your loan, adds another level of complexity to estimating your total costs.
Here is a quick example to help you understand how paying off a loan faster affects your actual APR if you pay off a loan faster. Let’s assume that you have a $200,000 loan at a 4% interest rate for a 30-year term, but hold the loan for different lengths of time:
|Lender Fees (including points)||Nominal Interest Rate||APR if paid off at end of 30 years||APR if paid off at end of 5 years||APR if paid off at end of 3 years|
As you can see in the chart above, if there are high upfront costs, then the shorter the length of time that you hold on to the loan, the higher your actual APR. If you don’t have enough cash available to pay the upfront fees, you have two choices:
- Speak to the lender about rolling the fees into the loan. (Make sure that your LTV won’t increase so that you need mortgage insurance).
- Take a lower fee loan, even if it has a higher APR.
APR – A Partial Tool to Compare Loans
Unfortunately, mortgage loans are complicated, technical and come in a variety of forms. Besides the points discussed above – the amount of time you hold on to the loan, and the type of fees you use to calculate the APR — it is difficult to compare between different types of loans, due to these factors:
- Types of interest rates — fixed vs. adjustable: Since it is impossible to know the future interest rate on an ARM, any APR for an ARM is just a guess. The norm is to adjust the interest rate based on what it would be today. Obviously, in a low interest rate market, that is not likely.
- Types of payment plans: If your mortgage has interest only payments, or a balloon payment, then the APR does not include that type of risk into its calculation.
Prepare your financial plan before you take a mortgage loan. Know how much money you can afford to pay each month. Take out a mortgage loan that is appropriate to your long-term plan to build equity. Learn about the advantages of 10-year, 15-year and 30-year mortgage loans. Check to see if a fixed rate or an adjustable rate mortgage is most appropriate to your risk level.
Finally, shop around and check all mortgage rates and fees. Check the different APR’s with a grain of salt.