What is APR? Is it a Good Comparison Tool?
APR, which stands for Annual Percentage Rate, is a calculated number that reflects the cost to borrow money as a yearly percentage. Let's see how this works with some numbers:
Loan Amount: $300,000
Interest Rate: 6%
Loan Term: 30 years
Closing Costs: $5,000
Interest Over the Life of the Loan: $347,514.57
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Note: Closing Costs here means actual fees associated with closing on a purchase or refinance transaction.
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The APR calculation starts by figuring out the total cost of borrowing. This is the total of the closing costs and interest paid, which is $352,514.57. Then we ask the question: what interest rate would have caused the borrower to pay $352,514.57 in interest (even though that is not the reality)? The answer is 6.157%, so that is your APR.
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Firstly, not every fee is an APR fee. Government regulators have assigned every fee as either an APR fee or a non-APR fee, driven by the following question: if the borrower had elected not to borrow money (eg: if a home purchase was for cash), would they have still paid this fee? If the answer is yes, then it is not an APR fee (because the fee would not be a 'cost of borrowing'). If the answer is no, it is an APR fee. Unfortunately, this rational philosophy breaks down when it comes to refinances. Any fee labelled an APR fee is an APR fee on either a purchase or a refinance, even though on a refinance you could argue every fee should be an APR fee (all fees charged are required in relation to the borrowing of money). Another twist to know is with regards to ARMs: how can we calculate APR if we don't know what the interest rate will be over the life of the loan? We can't truly, so ARM APRs are calculated much higher as a conservative measure.
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Is a Lower APR Always Better?
Given this understanding of APR, it would be natural to conclude that the offer with the lowest APR is the best for all borrowers. While this is true for a borrower who keeps a mortgage to term (eg: keeps a 30yr mortgage for 30 years), it can get more complicated for borrowers who sell, refinance, or pay a mortgage off early. The next section gives some examples to clarify when and why borrowers might benefit by taking a mortgage with a higher APR.​
Here are examples comparing interest rate options for a 30yr fixed mortgage of $300,000.
Source: Bankrate Mortgage APR Calculator
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-When you pay points for a lower interest rate, you pay more upfront but save more over time. When you avoid points, you pay less upfront but pay more over time.
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-In this example, the 6.5% option costs the least if the loan is held for only three years. The loan could come to an end in one of three ways: the home is sold, the loan is refinanced, or the borrower pays the loan off early.
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-In this example, the 6% option costs the least if the loan is held for ten years, and the gap widens significantly by the time the loan is held for the full thirty years.
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-There is no ‘best’ option presented. Which option is best for a borrower will depend on their plans and expectations. If this is a borrower’s forever home and they do not expect to refinance in the near future, then it may be best to pay the discount points. If a borrower believes there will be a refinance opportunity in the next couple of years, then it may be best to avoid paying discount points.
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Is APR Useful in Shopping Lenders?
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It can be useful or misleading depending on how you you it:
-From the table above, you can see that a lender can make offers of equal quality but with varying APRs, so simply comparing one APR to another is not going to help you accurately shop, and could actually lead you to accepting a worse offer
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-The lower APR is only the better offer if all offers you are comparing are for the same interest rate. If the rates are the same, the only reason for a difference in APR is the fees. So the offer with the higher APR has the higher fees. Yet still, there are limitations to this approach:
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a) As noted under the "Where APR Gets Complicated" section, not all fees are APR fees (even when they philosophically should be)
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b) Lenders are required to estimate third-party fees, many of which will end up being the same regardless of the lender you select. If you shop based on APR, you may inadvertantly turn down the better offer due to quoting third-party fees higher than the competition did.
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c) Mortgage mailers use low APR offers to attract attention, but those offers are likely stacked with tens-of-thousands of dollars in fees. This stuff is complicated, and a lower APR sounds better; don't fall for those ads you already suspected were too good to be true!
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-Collect offers from lenders reflecting the same interest rate
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-Do the following calculation:
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Anything in Section A (these are all lender fees, by definition)
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Anything in Section B (except appraisal - these can be counted as lender fees)
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Subtract any Lender Credit (if any, it will be found under Section J) =
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Total Cost (can be negative)
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-Whichever lender has the lowest total cost has the best offer!
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-Keep one other element in mind: Title Fees (Section C). While this is a third-party fee you can shop for, most borrowers don't and go with whoever the lender selects. So if one lender has a cheaper title partner than another, it is reasonable to add title fees to your calculation. But before you do, ask the lenders you are considering how accurate the title quote is. At Twilight Home Loans, we only use extremely cost-effective title providers. Our quotes also do not use estimated title fees; we get a quote from our title partners that will stand good through closing.
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-Lastly, if you are going to consider other rate/fee combinations, you would have to repeat this process to ensure you are getting the best offer: just because a given lender has the cheapest 6% option doesn't mean they have the cheapest 5.875% option (although it is likely they are better across the board, and that's a lot of work)
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-In the example from the table, 0.25% costs 1 point. In reality, there is no set rate of exchange between the interest rates and points. It can vary by day, scenario, lender, and more. Speak with one of our loan originators to see what options are available to you for your scenario.
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-This example compared lower rates with discount points to one with no discount points. Most of the time, you can even choose a higher rate that has ‘negative points’, which is called ‘lender credit’. The math considerations are the same: with lender credit, you pay less upfront but more over time than you would by taking a lower rate without lender credit.