July 12th, 2011 3:56 PM by Dana Bain
Don't believe the hype -- you can't shop for loans by APR. APR is the most easily manipulated number in the mortgage business.
What Is "APR"?
More commonly called APR, Annual Percentage Rate is a government-made math formula. It aims to measure the total cost of borrowing over the life of a loan.
APR is equal to (your loan size) + (your loan costs) + (your interest charges over time).
You can find your APR printed on the top-left corner of your Federal Truth-In-Lending Disclosure, as shown above.
After taking an application, when quoting an interest rate, loan officers are required to disclose a loan's APR to you, too. This is for consumer protection reasons; APR is supposed to make clear the best of two or more loan options.
APR is touted as an "apples-to-apples" comparison tool. It fails, however.
APR can't be used to make an apples-to-apples comparison because the loan with the lowest APR isn't always best for you.
APR Can't Be Your "Apples-To-Apples" Tool
Banks and lenders love to promote "low APR loans" online. Unfortunately, low APR doesn't translate to "good deal".
The APR formula is flawed. It makes assumptions about the future, and predicting the future is impossible.
The biggest APR assumption is that you'll hold your mortgage for its full term, and never pay it sooner. It assumes you won't refinance or sell. In other words, if your loan is a 30-year fixed rate mortgage, the APR is based on a full 30-year term. If you sell or refinance prior to Year 30, the math used to make your APR becomes instantly flawed and "wrong".
This is a big deal when comparing loans with points to loans without points.
If we only looked at APR, a loan with points will have a lower APR in nearly all cases. This is because loans with points have lower interest rates which means fewer interest charges over 30 years. However, if you were to sell or refinance within the first few years, the long-term savings of a lower rate are never realized.
In this example, the higher APR loan would have been the better choice.
APR is affected by other assumptions, too.
First, loan costs are included in the APR formula and third-party costs such as appraisal and title services are sometimes unknown at the start of a loan. As a result, banks may inadvertently understate them.
This would make the APR appear lower than what it really is, and can misdirect a consumer to the wrong loan.
And, second, for adjustable-rate loans, APR has to make assumptions about how a loan will adjust during its 30-year term. If two lenders use different set of assumptions, their APRs will differ -- even if the loans are identical in every other way.
The lender whose adjustments are most aggressively-low will present the lowest APR.
This, too, can misdirect a consumer.
APR is not the metric for comparing mortgages -- it's a metric. And, sometimes, the best way is the easiest way. Look at rates and look at fees. Beyond that, the rest can be smoke-and-mirrors.