In an effort to regulate advertising in the mortgage industry, the federal government began requiring lenders to state the APR of the loan in all advertisements. The APR, Annual Percentage Rate, is a more accurate indicator of the overall cost of the loan and allows consumers a way to compare various loan scenarios.
Before, lenders may have advertised a rate below the market fixed rate making it appear they were offering the best mortgage rates. But because fees and points were not stated, the overall costs of the loan was actually much higher than a higher interest rate loan with lesser or no fees.
In the calculation of APR, the interest rate along with points, loan origination fees, documentation fees and other fees is included. APR is not a foolproof way to decide on the best loan. Not all lenders include the same fees in the calculation of APR, which can skew the number. Perhaps the easiest way to understand APR, is by looking at examples.
First, let's look at a simple calculation: In the newspaper, Lender A and Lender B are both advertising rates of 6%. At first, it appears you could go to either lender and get the same deal. But Lender A's APR is listed as 6.385%, while Lender B's APR is listed as 6.287%. It is now obvious that even though the rates are the same, Lender B has the better deal because the APR is lower. In this scenario, the APR simply highlights that Lender A's fees are more then Lender B. APR is a great tool to use when the interest rates are the same.
But what if the interest rates are different? In many cases, you cannot go by the APR alone. In the following example, you will see that how long you plan to stay in your house can affect which loan is the best, regardless of APR.
| ||Loan A ||Loan B |
|Home Price ||$100,000 ||$100,000 |
|Term ||30 Years ||30 Years |
|Interest Rate ||6% ||5.7% |
|Origination Fees ||None ||1% = $1,000 |
|Points ||None ||3 = $3,000 |
|Processing Fees ||$500 ||$1,000 |
|Total Fees ||$500 ||$5,000 |
|Payment Amount ||$599 ||$580 |
|APR ||6.047% ||6.177% |
|Total interest paid (30 yrs) ||$115,838 ||$108,944 |
|Total loan cost (30 yrs) ||$216,338 ||$213,944 |
|If house was sold in 5 years, total cost ||$36,473 ||$39,824 |
At first glance, Loan A is the best deal with an APR of 6.047%. Even though Loan B's interest rate is lower, once you add in the fees, the APR is higher than that of Loan A.
However, let's assume you plan to live in this house for the full thirty years of the mortgage. You will find that the total cost of Loan A is several thousand dollars more than the total cost of Loan B, making Loan B the better choice.
How can that be when the APR is lower on Loan A? The difference in payment between A & B is $19.15 per month. In order to recoup the difference in closing costs of $4,500, you will have to stay in the house for 235 months or 19 ½ years. Up until that point, Loan A is the better choice. After the 19 ½ year mark, Loan B is the better choice because you are now truly saving $19.15/month.
For example, look at the total cost if you only stayed in the house for five years, Loan A saves you more than $3,300. This is because you have only had 60 months to recoup the closing costs of Loan B.
Figuring out which loan has the best mortgage rates can sometimes be a very frustrating task. Your lender should give you a good faith estimate within three days of your application. This document lists all closing costs associated with your loan and can help you make the best decision.
A simple calculation is to take the total loan payment multiplied by the number of months you plan to stay in your home. Then, add the closing costs (origination fees, points, processing fees, etc.). Calculate this figure for several loan scenarios and then compare the numbers. This can help you decide on the best loan based on your individual situation.