Posted February 17, 2014Tweet
You're shopping for a mortgage and you want today's absolute best deal. Don't we all.
However, finding that "deal" may not be as 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 often 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.
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.
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 :
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.
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.
The important thing to remember is that APR is not the metric for comparing mortgages -- it's merely a metric. The better way to compare two mortgage rate offers is to look at the mortgage rates as compared to the fees. APR should have nothing to do with it.
Experts recommend that you shop for a specific mortgage rate, then compare loan fees across banks at that specific rate. Or, shop for zero closing costs whatsoever and compare mortgage rates across banks. You can't do both at once and can't shop for a mortgage by APR.
Ignore the APR and shop with smarts. Get started with a rate quote today.
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.
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2014 Conforming & FHA Loan Limits
Mortgage loan limits for every U.S. county,
as published by Fannie Mae & Freddie Mac, and the FHA.