Comparing multiple loans simply by looking at the offered interest rates side-by-side is simple, but when you throw in lender fees, mortgage insurance, and certain other charges it can become increasingly difficult to figure out which is the better deal in the long run. This is where the APR, or Annual Percentage Rate, comes in. The APR is the total cost of all the finance charges, including the interest you pay, any points or lender fees, mortgage insurance, and certain other settlement costs associated with obtaining the financing, over the life of the loan, represented as a percentage.
Most of us have some familiarity with the APR from car commercials. Auto loans are often expressed in terms of APR rather than an interest rate. This is because, in most cases, the interest rate and the APR on a car loan are the same thing. The dealer may charge some additional fees over and above the actual cost of the car, but those fees would be charged regardless of how you are paying for the vehicles. As a result, the only finance charge you pay is the interest on the loan; therefore, the interest rate and the Annual Percentage Rate are the same.
When you purchase a home, there are several settlement costs that you would not have to pay if you were paying cash. For example, if you were paying cash there would be no points or other lender fees, no mortgage insurance paid upfront or in monthly installments, and no title insurance charges for the lender’s policy.
The APR has always had some shortcomings in the value it provides as a comparison tool. First, several of the costs that are included in calculating the APR are not fees controlled by the lender, rather they are estimated by the Loan Officer. A good Loan Officer will often use slightly higher estimates of fees to provide you with a worst-case cash-to-close figure to help you prepare for settlement. After all, who wants to show up to closing and find out they have to pay more than they anticipated, right? But this practice could make that Loan Officer’s APR higher than another Loan Officer who is underestimating certain charges. Charges that will ultimately be the same regardless of which of the two Loan Officer’s is chosen.
Another shortcoming is that the APR reflects the costs over the full term of the loan, typically 30 years. But the average person does not keep the same mortgage loan for 30 years. The result is that the interest and other costs that are paid over the full term of the loan will be weighted much heavier in the APR calculation than one-time fees paid at closing, even if those one-time fees are excessive. For example, getting a lower interest rate in return for paying two points at closing might show a more favorable APR than slightly higher interest rate at 0 points, even if two points is an exorbitant amount to pay for the offered decrease in rate. Just because the APR is lower, doesn’t necessarily mean it is a better deal.
Recent changes to the Loan Estimate and Closing Disclosure, both of which are required by law, have addressed some of these shortcomings. The APR is still provided on both forms, but the Loan Estimate now provides some additional measures to compare loans such as a snapshot of the total you will have paid in interest, mortgage insurance, and loan costs in 5 years versus how much of the principal balance you will have paid off over the same span of time. Comparing these figures on different loan programs often provides a much better reference point to make an informed decision.
If you are interested in learning more about this or any other relevant topic, or if you would like to get more information about your specific situation, do not hesitate to contact me at your convenience. My goal is to provide you with all the information you need to make informed decisions about your financial future.