It’s a myth that you can shop for a mortgages using Annual Percentage Rate (APR) calculations. You can’t shop for loans by APR.
No matter what your loan type — FHA, conventional loans, VA, USDA or jumbo — shopping by APR makes it less likely that you’ll choose “the best deal”. APR is among the most easily manipulated numbers in the mortgage business. Of course, some lenders count on you not knowing that.
What Is “APR”?
More commonly called APR, Annual Percentage Rate is a government-concocted math formula. It’s meant to measure the “true 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 much will have to be paid over 30 years to pay off the loan in full.
APR answers 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 Federal 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 along with every rate quote, it’s believed that customers will be better informed and can make better loan choices.
In some cases, this is true. In many cases, it is not.
APR is not the “apples-to-apples” comparison tool it’s advertised to be. This is because the loan with the lowest APR isn’t always the loan that’s best for you.
APR Can’t Be Your “Apples-To-Apples” Tool
Banks and lenders love to promote their “low APR loans” — especially online. In fact, most mortgage marketplaces sort loans by APR by default. This means that the loans with the lowest APR will show up first on your list of approved mortgage lenders.
Unfortunately, getting a low APR doesn’t translate to getting a “good deal”. This is because the APR formula is flawed.
Calculating for APR requires a lender to makes serious assumptions about the future and, as we all know, predicting the future is impossible.
For example, here are three egregious assumptions that the APR formula makes about your loan:
- The APR formula assumes that you will hold your loan for 30 years
- The APR formula assumes that you will never make an extra principal payment
- The APR formula assumes that you will never refinance or sell your home
In addition, for loans with mortgage insurance, a category including conventional loans, FHA loans, USDA loans and others, the APR formula is forced to assume a specific date upon which your mortgage insurance “goes away”. This is next to impossible.
It’s for these reasons that Annual Percentage Rate fails.
As another example, when comparing loans with discount points to loans without discount points, a loan with discount points will often boast a lower APR — even though the loan may not be “cheaper”, necessarily. Online lenders know this and it’s why their “deals” can look great online, but not so great once the paperwork gets signed.
Shopping by APR can be the worst way to shop for a loan — your loan may front-load with fees.
APR Assumes You’ll Never Sell, Never Refinance
Your loan’s APR can be negatively affected by other assumptions, too. One such way is with respect to loan fees.
When you ask for an APR from a lender, at the start of your process, mortgage loan costs are often unknown. However, third-party loan costs such as appraisal and title services are required to be estimated. This is one reason why you get a Good Faith Estimate.
There’s a reason it’s not called the Good Faith Iron-Clad Guarantee. Banks don’t know each fee to the penny at the start and when a banks estimate fees, Annual Percentage Rate becomes an estimate, too.
Another APR estimate is tied to adjustable-rate mortgages (ARMs).
The government’s APR formula tells banks to make assumptions about how your loan will adjust over its 30-year term. Banks are told to estimate how far rates might rise over 30 years, and how far they might fall. The estimated payments of an ARM affect the APR.
When two different banks apply two different schedules of adjustment, the result will be two different APRs. Despite equal mortgage rates and fees, the loan with the most aggressive ARM adjustment will show the lowest APR.
This, too, is misdirecting.
Compares Apples Or Oranges, But Not Both
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.
Shop for a mortgage rate, and compare loan fees at that rate. Or, shop for zero closing costs and compare mortgage rates on that plan. You can’t do both at once and can’t shop for a mortgage by APR.
Start with a fresh quote and see how today’s rates fit your budget. Ignore the APR and shop with smarts.