Shopping for a mortgage can be complicated, with lots of different factors such as interest rates, fees, points and loan terms to take into account. Is there a simple way to compare offers from different lenders that cuts through the confusion and shows which is the best deal?
Actually, there is - almost. The annual percentage rate (APR) on a mortgage loan is designed to help you do just that. Although it's not foolproof and you sometimes have to consider other factors as well, it is a great tool to help cut through the clutter and figure out what the bottom-line cost of a mortgage will be.
Rates, fees rolled into a single figure
The APR takes all those things that make it hard to figure the cost of a mortgage - the interest rate, lender fees, discount points and loan duration (term) - and rolls them into a single number - the annual percentage rate. This number, which is similar to - and often confused with - the interest rate, shows what your actual cost of borrowing is. By law, the APR must be listed on the Truth-in-Lending statement all mortgage lenders are required to provide.
For example, consider two loans, both for $200,000 at 5 percent interest. Just for the sake of an example, we'll say the first loan has no fees or points paid, so the borrower is simply borrowing $200,000 at 5 percent interest. On the second loan, however, the borrower is paying $5,000 in fees and points, which are included in the $200,000 balance the borrower owes. So in reality, the borrower is getting a $195,000 loan, with a $5,000 charge added right on top.
The APR takes into account this $5,000 charge in figuring the cost of borrowing $195,000 - the amount actually available for the borrower to use. It does this by spreading the $5,000 over the term of the loan - in this case, we'll say 30 years - and rolling it into the interest rate. Taking that into account, it means the borrower is effectively paying an annual rate of 5.218 percent to borrow $195,000 over 30 years - even though the actual terms of the loan are $200,000 (including fees) at an annual rate of 5 percent.
Shows true cost of borrowing
That's essentially how the APR works. It takes any fees you pay for a mortgage loan or refinance, and recalculates their cost as part of an interest rate. It's a handy way of comparing loan offers with differing fees and interest rates. For example, you may have one loan offer at 5.5 percent, zero points and $2,500 in fees, vs. another at 5.25 percent, two points and $7,000 in fees. Your APR on the first might be 5.6 percent, but 5.75 percent on the second. The first loan is the least expensive, even though it has a higher interest rate.
The APR can be used to compare offers on adjustable rate mortgages, even though the rates may fluctuate over time. The way that works is, the APR is calculated assuming you'll have the mortgage for the full term of the loan and simply pay the new rate whenever it resets. Because no one can predict what interest rates will do in the future, the calculation simply assumes the base rate, or rate index, that rate resets are based on will remain unchanged, so the calculation simply depends on how much the resets vary from the base rate.
Less accurate for loans held only a few years
The one major problem with relying solely on the APR to compare mortgage offers from different lenders is that it assumes you'll hold the mortgage for the entire term. Remember, in our example above, the $5,000 in costs was spread over 30 years. However, if you sell the home or refinance before you've fully paid off the mortgage, you've had less time to amortize the fees - increasing the effective interest rate of the loan.
As a result, the APR tends to favor mortgages with low rates and high fees. If you think you might sell or refinance within 7-10 years, a loan with a higher rate and lower fees might be better. Though the APR can act as a rough guide, to get a definite answer, you'll need to plug the interest rate, fees and other information in to a mortgage calculator and see how they compare for the length of time you plan to have the home.