When it comes to mortgage loans, there is a lot of emphasis on APR, or Annual Percentage Rate. It has become the standard for comparing different mortgage loans. While the purpose of APR is a noble cause – the approach is highly flawed.
Today we’ll be digging into the real mathematics behind APR and looking at the best way to compare loans.
The Purpose Of APR
APR is the amount of interest on your total loan amount that you’ll pay – averaged annually over the full term of the loan. It reflects the interest rate as well as other costs such as lender fees, broker fees, discount points and some closing costs.
It attempts to allow a consumer to decide between different types of mortgages, with varying rates, points and fees.
For Example: Is it better to pay 4.25% with 0 points, or should you pay 2 points and bring the rate down to 3.75%?
Let’s break it down:
The Amount Financed
The amount financed (Page 5 of your Closing Disclosure) shows the amount of money you’re borrowing from the lender, minus most of the upfront fees the lender is charging you. These “prepaid fees” that reduce the loan amount on the Truth in Lending disclosure are amounts of money the lender will receive when the loan closes.
Let’s take a simple example: Say your loan is $100,000, and you must pay the lender closing fees of $1,100.
The calculation looks like this:
$100,000 (Loan) – $1,100 (Lender Fees) = $98,900 (Amount Financed)
Your Truth in Lending will show a loan amount of $98,900. When you close on your loan, the lender receives the $1,100 in fees, and the net amount you’ll receive, or the amount financed is $98,900.
The amount financed is the number used to calculate the APR.
From Amount Financed To APR
Once the amount financed of $98,900 is established, we use the monthly payment on the loan as a function of the loan amount to calculate the APR.
- $100,000 Mortgage
- Interest Rate on a 30-year Fixed: 4.25%
- Monthly Payments (P&I): $492
A $492 monthly payment on this $100,000 mortgage corresponds to a 4.25% interest rate on a 30-year fixed loan. To calculate APR, we take the 100,000 mortgage and replace it with the amount financed. The $492 monthly payment on the $98,900 amount financed corresponds to a rate of 4.35% …this is the APR.
Comparing Loans Using APR
We’ll take what we’ve used in our previous examples and call it Loan 1. To compare loans, we made a few changes in loan 2. In the second loan the client pays $2,000 for a ½ percent rate drop (from 4.25% to 3.75%). The result is a $29/month lower P&I payment. The amount financed also decreases to $96,900. The payment of $463 as a function of $96,900 now results in a APR of 4.01%.
When you compare APR, loan 2 looks like the better option. But is it? Let’s take a look!
A True Breakeven
While loan 2 saves you $29/month, it costs $2,000 more upfront. Dividing $2,000 by $29/month shows that it takes almost 6 years to breakeven on the upfront funds.
What if instead of paying the extra money upfront, you reduced your loan amount by the same $2,000? This brings the difference in payment to $19/month vs. $29/month. The resulting breakeven period is now almost 9 years – providing real savings only after this time, even though the APR is lower.
Since APR spreads the fees paid upfront over the life of the loan, the comparison is only accurate if you plan to keep the mortgage for the entire length of the loan – typically 30 years. Since most borrowers do not keep their loan for the full period (they typically refinance or move), loan 1 is the better option for the first 9 years and would likely result in the best choice for the majority of borrowers.
- APR can be misleading, and for the most part, points are the wrong option for borrowers.
- For APR to be accurate, it assumes that you will have the loan for its entire duration. Therefore, no prepayments, refinances, or selling of the home for the entire life of the mortgage.
- APR also assumes zero inflation – not taking into account the value of money now is worth more than dollars being paid back 20-30 years later.
The Bigger Picture
APR is a flawed way to compare loans and getting the lowest APR doesn’t mean you’re doing the best thing for your overall financial position. You need to look at the big picture. It’s much better to utilize the more accurate compassion of cost vs. savings and take into consideration the value of money spent today for upfront costs to determine a true breakeven target.
All scenarios are for illustrative purposes only. Actual loan costs, rates and fees may vary. This is not a offer of credit or a commitment to lend.