Caller: “Can you tell me what your APR is?”
Me: “Sure. Can you tell me what APR is?”
So this really happened. Many times, in fact. This is your garden variety, otherwise-intelligent consumer trying to shop for a mortgage. This is someone earnestly trying to figure out the best deal on a home loan. And yet, most often, they have absolutely no idea what they are doing when it comes to the annual percentage rate, or APR, on a mortgage. But I don’t blame them. The point of this blog is not to make anyone look or feel stupid. In fact, it’s the opposite. APR was meant to help, but I have experienced that our regulators and our industry have done a poor job of explaining how it works and how one calculates it. If we reduce it to plain language and easy examples, APR starts to makes sense and, most importantly, can be put in its rightful place in the shopping process. Spoiler alert — APR is not the be all, end all of mortgage research. As we’ll see, it’s just a numeric representation of costs —- costs that can be deduced elsewhere in the loan documentation you’ll receive. But let’s get started on APR. It is worth understanding.
APR is the “price per pound” (PPP) of the money you are borrowing. If you go into a supermarket with the lofty objective of buying sugared breakfast cereal at the lowest price possible, you might just come across boxes of different sizes (and prices). How will you determine the best deal? You will reduce the cereal to “price per pound,” or in this case, the price per ounce. If a 32oz. box costs $5.99 and a 24oz. box costs $4.99, some basic math tells us that the per ounce cost for the 32oz. box is $.19, For the 24oz. box it is $.21 per ounce. You’d be better off buying the larger box.
Now let’s say that you’ve decided to step up your game from frosted flakes to four bedrooms. You need a mortgage and Lender A tells you that you can get $400K 30-year fixed rate mortgage at a rate of 4.000% with a cost of $3000. Lender B says you can get a loan of the same size for 3.875% at a cost of $7000. How do you determine the better deal?
APR is a lot like triangles. Remember in high school algebra (sorry for the flashback…) we learned that the angles of a triangle must always equal 180 degrees? Remember how we were told that if one angle decreases, so too must another increase? Well, this is APR. Let’s go back to our example above:
- Note Rate: 4.000%
- Loan Amount: $400,000
- Payment: $1910
Follow me so far? Good. Now let’s introduce cost. If it costs you $3000 to get $400K, then the “net” funds that change hands will really be $397K (yes, you still get a loan of $400K…). But since you have a fixed rate loan and a payment of $1910 that cannot change, what would your rate need to be to produce a payment of $1910 at a loan amount of $397K? The answer is your APR, and in this case it is about 4.07%. Now, what about our other option from Lender B? Will APR be higher or lower?
- Note Rate: 3.875%
- Loan Amount: $400,000
- Payment: $1881
Again, let’s do our “net” math. You have $393K changing hands ($400K – $7000) and a fixed payment of $1881, so your APR is 4.02%. If you are looking for the lower APR, you found it. But if you are looking for the loan with less costs, the 4.000% Note Rate is perhaps the better fit.
You always make your mortgage payment based on your Note Rate (the actual rate) and not the APR. I think this one confuses a lot of would-be borrowers. APR is an aid in the shopping process. It is never the basis for your monthly payment.
Trying to determine the APR on an ARM loan is an exercise in futility. By definition, ARM loans will have a period of time where the interest rate is subject to a combination of the index plus a margin. The index will change during that time. Because of this, creating a static APR calculation with accuracy is impossible. If you are weighing an ARM loan versus a fixed program, you will have to review a cost itemization or Loan Estimate to calculate total costs for each option. There is no shortcut. While on the topic of things that can skew APR, PMI is another one. If you’re weighing two loans with PMI, or one with and one without, know that PMI can wildly increase APR to the point where it ceases to be an effective shopping tool.
Don’t lose sight of what you’re attempting to do with APR. Namely, seeking to determine how much it costs to get any interest rate on any loan. If you review all of the above and still don’t feel confident, you are not alone. To make matters worse, there is no real uniformity in what costs and fees get included in APR. One lender to the next, you’ll see some variation. But here too, a rule of thumb should be that a lender should include any fee in the APR that could not otherwise be avoided if the borrower paid cash for the home. For example, an appraisal. You need that for a mortgage process, you do not if you pay cash. So an appraisal fee should be included in APR, etc.
We’re here to help with any questions about Note Rates, APR and the costs and components that impact your mortgage pricing. Smart shopping is always a good idea. Thinking that APR accomplishes that goal alone is not.
Don’t know much about algebra,
Robert J. Spinosa
Vice President of Mortgage Lending
Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709
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