Why the APR is “NOTE” correct!

Comments(0) By Mike Miller •June 10th, 2008

The “annual percentage rate” (APR) listed with any mortgage generally causes more confusion than it’s worth for most homebuyers. Making matters worse, most mortgage professionals don’t really understand it.

An APR calculation is required on mortgage offers to help people make sense of all the figures flying around. The ultimate goal is accurate comparative shopping. Unfortunately, some lenders can and will manipulate APR; and the assumptions used generally make APR estimates unrealistic.

APR is at best a theoretical statistic. Your mortgage carries a stated interest rate. But it actually costs more, when you account for points paid up front and closing costs imposed by the lender. APR tries to take all this into account. Unfortunately, it usually does little more than confuse homebuyers. In fact, the calculations associated with APR frequently scare homebuyers.

Under APR math, you take the loan amount, which is easy for anyone to understand, and turn it into the “amount financed.”

Looking at an example: If you put 10 percent down on a $200,000 home, the loan amount is $180,000. Let’s say you pay $5,000 in points and closing costs. That means the amount financed is $175,000. Homebuyers panic when they see the $175,000, thinking that they suddenly have to come up with another $5,000 at the last minute to pay the seller. But in fact, that figure comes up merely to calculate APR and has no real barring on the transaction.

Another source of confusion and misleading comparisons stems from what is known as “interim interest.” For various reasons, mortgage payments are almost always timed with calendar months. So if you close sometime during the month, then you have to pay that little bit of extra interest until the first payment is due. Interim interest can alter the APR calculation by several basis points, but that does not really mean one mortgage is better than another. It merely means that one closing date is further away from the end of the month than another. Lenders can play games with interim interest to get lower hypothetical APRs on advertised loans. Laws regarding APR actually allow some wiggle room for this sort of thing. A lender can be off by as much as 1/8 of a percentage point. Unfortunately, in a competitive mortgage market that can mean the difference between winning and losing a customer.

Homebuyers generally aren’t aware of the faulty assumptions that go into APR calculations. These assumptions can lead to people taking on the wrong kind of mortgage.

APR math relies on two very bad assumptions:

APR assumes zero inflation. In other words, $1 today equals $1 30 years from now.
APR assumes the homebuyer will never move, prepay, or refinance.

In fact, a typical family stays in the same house about nine years, and refinances once. That brings the average mortgage duration down to less than five years.

So most APR assumptions are grossly unrealistic. Adjustable-rate APR calculations are based on even more assumptions, making them even less meaningful.

So what do you do? Take a look at the APR, and then forget about it.

Don’t pay points, unless you plan to stay in the house for at least 10 years and won’t refinance. Chances are good you will move before 10 years is up, or you will refinance.

It is much easier to compare different offers if they don’t include points. You should focus on the type and amount of the mortgage, and on the quality of service of the lender.

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Filed Under: Borrower Tips