APR, interest rates & points

APR, the acronym for annual percentage rate, has been a confusing number for most borrowers. Many borrowers are advised to shop for the best deal based on APR, whether or not the lowest APR is the best deal for you is debatable.

The combination of interest rates, points you are paying, plus portions of your closing cost form the components of the APR calculation. In general, any items of the closing cost you are paying related to getting the mortgage is part of the APR. Examples are: any lenders charges, mortgage insurance and points are part of the APR while surveys, attorney’s fees and termite inspections are not. The actual calculation involves adding those closing cost related to the loan as part of your finance charges and spread it over the term of the loan. Therefore, the APR will always be higher than your actual rate, the rate your monthly payments are based on.

The fallacy of shopping for the lowest APR is mostly because the calculation of the APR is based on the term of the loan. The APR disclosed on the TIL, truth-in-lending disclosure, required by law is assuming you will pay the loan off for the entire term of the loan; for example paying off a 30 year mortgage in 30 years. If your loan is paid off early or refinanced the APR is different than the original APR since the cost is spread over fewer years. For the same loan you can usually get a lower APR by paying some points, but if you pay off the loan in the first few years, you would not reap the benefit of buying down the lower rate.

Another fallacy is APR calculation for adjustable rate mortgages (ARMs), since assumptions have to be made for future rate adjustments, APR calculation for ARMs are basically meaningless. Other reason APR can be misleading is there are some leeway for the calculation to meet the federal laws. By comparing two loans with APR within 0.25% of each other may or may not tell you the better loan just by the fact there are different ways of calculating APR to meet the federal requirements.

To me the best way of calculating the APR is to start with a zero point loan with no origination or discount points, this will give you a way to shop for the base loan. Then decide on how long you intend to keep the loan, the longer you intend to keep the loan the more beneficial it is to pay some point to buy the rate down. Most lender fees are within a few hundred of one another, unless there are some exorbitant fees, they won’t impact the APR much.

You will probably find comparing the monthly payment amount for different rate more helpful in deciding the best option/APR for you.