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Don’t Use APR To Shop For A Mortgage

Gina Pogol
The Mortgage Reports editor

Can You Trust APR As A Rate Shopping Tool?

You see it almost daily when you’re shopping for mortgage rates: look at the annual percentage rate (APR) to find the “best deal” on your mortgage.

The articles and news reports say to get multiple rate quotes and choose the one with the lowest APR.

That could be a bad idea. The loan with the lowest APR could be far and away the most expensive.

Verify your new rate (Nov 18th, 2018)

What Is APR?

APR is a calculation created by the government to make it “easier” to compare loans with different combinations of interest rate and fees.

Unlike the stated interest rate, the APR incorporates both the interest and the loan costs.

For instance, a loan offer might come with a 3.75 percent interest rate and a 3.95 APR.

A zero-closing-cost mortgage has the same rate and APR. If you borrow $100,000 at a 4.0 percent interest rate, and there are no other costs, your APR is also 4.0 percent.

When you pay loan fees yourself, your APR rises.

The following examples show how loan costs affect the APR on a mortgage of $100,000.

 Rate  Fees  Payment  APR 
 3.5%  $5,000  $449  3.90%
 3.75%  $2,000  $463  3.91%
 4.0%  $0  $477  4.00%

The 3.5 percent rate comes with the lowest APR. But if you choose this option, you’ll probably pay too much for your home loan. Here’s why.

Verify your new rate (Nov 18th, 2018)

APR Assumptions Are Often Untrue

The problem with APR is that it only “works” if several assumptions hold true.

  • You’re keeping the loan for its entire 30-year term
  • Every lender includes exactly the same costs in its APR calculation
  • You’re comparing identical loans

The APR calculation breaks down if you refinance in five years, for instance, or you compare a 30-year fixed mortgage with a 5-year adjustable rate loan.

Suppose you choose the 3.50 percent loan because it has the lowest APR.

You pay $5,000 upfront, and in exchange, you pay $28 a month less.

Your total payments over the life of the loan will be about ten thousand dollars less than if you paid nothing upfront and took a 4.0 percent loan.

That’s a savings of $5,000, which proves that the loan with the lowest APR was indeed the best deal.

If, however, you sell your home after just five years (60 payments), you’ll have paid $5,000 upfront to save just $1,680. That’s a net loss of more than three thousand dollars.

So the “best” loan did not save you money; it actually cost you money. And that’s not even considering all the other things you might have done with that $5,000, like paying off credit cards or building your retirement fund.

APR Confusion For Short Loan Terms

Here’s another monkey wrench, brought to you by APR.

The following demonstrates what happens to the APR when changing the loan term from 30 years to 15 years.

 Loan  Rate  Fees Payment APR
 30-year  3.75%  $2,000  $463  3.91
 15-year  3.75%  $2,000  $727  4.04

The costs for the 15-year loan are the same compared to the 30-year one, but the APR is higher. Still, you pay thousands less in interest for a 15-year loan term.

A reasonable consumer might pick a 30-year loan, mistakenly thinking they are saving money.

Verify your new rate (Nov 18th, 2018)

Lender APR Calculations Differ

Lenders don’t all calculate the APR exactly the same way.

Some include the credit report fee, for instance, and some don’t.

These variances are minor, but could be enough to convince you to choose one lender over another. Both lenders could charge the exact same amount in real dollars.

When you receive lender disclosures, compare fee for fee, line by line. Don’t rely on the “easy” way of comparing the APR by itself.

You Can Do Better

The important factors to you, the mortgage consumer, are the loan’s interest rate and costs.

A Department of Housing and Urban Development (HUD) study of FHA closing costs discovered something interesting.  FHA borrowers who shopped “zero-cost” deals were more successful because all the confusing elements were taken off the table.

A zero-cost loan is one in which the lender issues a slightly higher interest rate in exchange for paying all closing costs.

These consumers compared rate only, and didn’t try to work out which lender charged the least fees.

This could be a good strategy for home buyers and refinancing households that simply want the bottom-line “best deal” on their mortgage.

What Are Today’s Rates?

Mortgage rates are hitting 3-year lows, and there have been few better times in history in which to shop around for a good rate.

Get a quote for your home purchase or refinance. All quotes come with access to your live credit scores, and no social security number is required to start.

Verify your new rate (Nov 18th, 2018)