Article APR Is A Poor Way To Compare Loan Costs

APR Is A Poor Way To Compare Loan Costs

So often when I quote a mortgage rate over the telephone to a first time home buyer in San Diego, I get asked immediately, “What is the APR?” I calculate it very quickly and quote it to the first time buyer. I immediately follow the APR quote with a disclaimer that APR is not an effective way to compare loan costs between loans. I continue, stating that the only reliable way to compare loan costs is to compare good faith estimates for each loan side-by-side. At some point in this conversation, I have to explain what APR is.

APR stands for Annual Percentage Rate. APR is the actual interest rate you would be paying on the money disbursed after all non-recurring closing costs were paid for by the loan. The interest rate and mortgage payment are initially calculated on the total amount borrowed. If the non-recurring closing costs were paid for through the loan, the final amount of money disbursed would be less than the original amount, but the mortgage payments would not have been reduced. The actual interest rate paid on the money disbursed – the APR – would be slightly higher that the quoted interest rate because the payment remained the same but the money disbursed after closing costs are paid is less than the original loan amount.

A loan’s APR will be shown on the Truth-In-Lending statement that should accompany the Good Faith Estimate that the loan officer is required to provide very early in the loan application process. A first time home buyer wanting to compare loan costs should compare the Good Faith Estimates, no the Truth-In-Lending forms. Let’s take a look at the reasons that APR should not be used to compare loan costs.

1) APR is a straightforward calculation for a fixed rate mortgage such as a 30-year fixed or a 15-year fixed. Most loan officers can calculate APR right on their financial calculators for these loans. As soon as a loan has any additional feature such as a variable rate component or bi-weekly payment thrown in, the APR calculation becomes much more complicated and difficult to explain.

2)The APR calculation can be misleading to those not thoroughly familiar with it. For example, if two 30-year fixed mortgages with the same APR but different loan amounts were compared, the smaller mortgage would be a better deal than the larger. As loan amounts grow larger, closing costs don’t increase proportionately. The only non-recurring costs that increase as loan amount increases are title insurance and points of origination and discount. A larger loan with the same APR as a smaller loan would likely have charged more points.

3) The APR on a loan does not reflect whether any of the individual non-recurring closing costs were overcharged. That can only be done by comparing good faith estimates side-by-side. This is the way closing costs should be compared.

4) APR does not tell whether any junk feeds have been added in. Once again, the only way to discover junk fees is to take a close look at the good faith estimate.

A first time home buyer should receive a good faith estimate and truth-in-lending form a few days after the loan officer has received your initial loan application. Ask the loan officer is he or she can guarantee the non-recurring costs on the good faith estimate in writing. I have no problem doing that. Look very hard at the good faith estimate for junk fees. As a general rule, any fee not paid to a third party except for points of origination and discount processing fees, and credit report fees are junk fees. Third-party fees would include those paid to the title company, the escrow company, the actual lender, the notary, the appraiser, and the county recording office. Recurring closing costs would include items such as property taxes and interest.

The costs listed on the good faith estimate, not the APR listed on the truth-in-lending form, are your keys to comparing loan alternatives.