Using "APR" to select your loan
CAN COST YOU MONEY

A borrower shopping for the best mortgage rate can easily be seduced by low rate offers that are accompanied by low annual percentage rates (APR). Federal law requires that APR be disclosed along side the actual interest rate as a means to help borrowers make a more informed decision on their mortgage.

The truth is that APR is a very poor way to comparison shop for a mortgage and can cause borrowers to make costly decisions. APR was created to provide a way for borrowers to account for costs associated with the mortgage. This sounds good because it may not be very easy to choose between a loan with a lower rate and higher fees or a loan at a higher rate with low fees.

The problem is that the APR calculation is based on bad assumptions. First, APR assumes zero inflation and that the value or buying power of a dollar today will be exactly equal to the value of a dollar 10, 20, or even 30 years from now. Next, the APR calculation assumes that the mortgage will never be pre-paid or paid. That means no refinancing or selling the home, which is highly unlikely since the average life of a home mortgage loan is less than four years. Just think about your own loans: Is it rare to see the same loan in place for even five years-forget 30 years?

The APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it wasn't spent on closing costs. Finally, APR does not take tax consequences into consideration. This can be significant, since higher fees on the mortgage may not be deductible, while the higher interest rate typically is deductible. Moreover, APR can be easily manipulated by bad lenders, making it totally worthless.

How does APR work? I like to explain it to my clients using triangles (see following figure).Look at the two graphs to illustrate the difference between interest rate and APR. The reason for the triangle is that there are three sources of input: interest rate, mortgage amount, and monthly payment. If you know any two of the three, you can calculate the third

Since any two of the three variables allows you to calculate the third, a $911 monthly payment for a $150,000 mortgage calculates to an interest rate of 6.125 percent.

But the APR calculation uses different information. The APR calculation only keeps the monthly payment information the same. Instead of the mortgage amount, APR uses "amount financed." This is the "amount financed" information on the Truth in Lending statement. Amount financed takes into consideration the fees that are lender imposed, such as application fees, points, commitment fees, and interim or per diem interest. So, amount financed is the mortgage amount less any lender fees, points, and interim interest. The more fees, the lower the amount financed. The monthly payment is then calculated as a product of the amount financed to give you the annual percentage rate or APR. So, the lower the amount financed, the higher the APR is. Amount financed can be manipulated by assuming a closing on the last day instead of the first day of the month. That would increase the amount financed and decrease the APR.

Here is a real example on a $150,000 fixed rate 30-year mortgage with zero points: Lender A is offering a great low rate of 5.875 percent and Lender B is offering a higher rate of 6.125 percent.

Let's look at the real story. The payment difference between the two is $24 per month. So is it worth paying $3,000 in fees to Lender A in order to save $24 per month? Hardly. It will take over 10 years for a borrower just to get back his investment-a bad choice when you consider that mortgage loans are typically retired within four years. To make the decision to go with Lender A even worse, if that's possible, borrowers rarely take the value of to day's dollars into account.

Rather than giving Lender A the windfall of your hard-earned $3,000, you should give it to yourself. Reduce the loan balance on your mortgage by the fees you are saving. In the example given, that would reduce the loan from $150,000 to $147,000. This makes the payment difference just $6 per month instead of $24 per month! The true time to break even is really 500 months (more than 40 years). So it is impossible to benefit from the higher fee program from Lender A, because the maximum period on the loan is 30 years or 360 months. One more thing: when you calculate your tax deduction on the payment difference, it makes even more sense to avoid paying higher non-deductible fees. The obvious correct choice is to go with Lender B, even though the APR is lower with Lender A.

The bottom line is that you should forget APR and think twice about those advertised low rates when they are accompanied by higher fees.

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