What Is Wrong With APR?

What is the difference between mortgage interest rate and APR?

When comparing mortgage loan options, you will see two percentages — the interest rate and the APR. The interest rate is the cost of the loan itself. The APR is the cost of the loan to you. Reading these definitions next to each other, the difference seems minimal. One, however, is more comprehensive to your understanding of a loan offer.  

Lenders determine interest rates based on a set of assumptions used to gauge how risky a loan is. The interest rates offered to you reflect how well you stack up to those assumptions, so you may see higher rates for lower credit scores or equity. APR incorporates the interest rate into a larger calculation that also includes the cost of the loan (closing costs, points, etc.). It should never be lower than the interest rate.

The intent of APR is positive and clear, but there are a few reasons why you should not shop by APR only, especially with mortgages that have high loan amounts, long loan terms, and multiple vendors providing you services.

Is APR reliable?

The whole point of APR, as opposed to simple interest rate, is to help you understand the true cost of a loan. The Consumer Financial Protection Bureau (CFPB) requires that an APR disclosed to an eligible mortgage applicant must be accurate within 1/8% on a fixed-rate and 1/4% on an adjustable-rate mortgage. This is just an example of a rule. There is extensive legal language and guidelines centered on APR. Lenders that do not follow the CFPB’s guidelines may be ineligible to close a loan and could be subject to penalty and/or fines. There are, however, some ways in which APR can be flawed or misleading when it comes to mortgage interest rates. Here are a few potential issues to keep in mind:

• It may not reflect your actual costs, so be sure to compare what fees are included in the calculation. APR includes many of the costs associated with a mortgage, but it may not include everything. Additionally, some lenders may exclude certain fees from the APR calculation (e.g., by increasing non-lender fees that are outside the scope of the APR instead), so it's important to carefully review and compare your loan estimates to confirm what's included.
• The costs are amortized over the full loan term against a high loan amount, which minimally impacts APR.  APR assumes that you'll keep the mortgage for the entire term, which may not be the case. If you plan to sell the home or refinance the mortgage before the end of the term, (e.g., the average life of a 30-year mortgage is around seven years), your actual APR could be drastically different from what the published APR suggests.
• It doesn't consider other factors that may impact the cost of borrowing: APR focuses solely on costs associated with the mortgage itself, but there may be other factors that impact the overall cost of borrowing, such as the tax implications of mortgage interest deductions.
• It may not account for different loan structures: Lenders calculate APR assuming a traditionally amortizing loan, where you will make fixed payments over the life of the loan. However, some mortgages have different structures, such as interest-only payments, which can make the APR calculation less meaningful.

What if I’m not keeping the loan the full term?

When you look at the APR for a mortgage product, the mortgage product's APR accounts for the full loan term against the full loan amount. The loan term is usually very long, e.g. 30 years, and the full loan amount is usually very high, e.g. 300k. Upfront costs typically leave the loan term and loan amount unchanged, so a lender can easily increase upfront costs to reduce the effective loan amount that you are borrowing to give you a lower rate knowing that the average life of the loan is much less than the full loan term.

When you're buying your first home, your first thought is probably not when you plan to move or when to refinance a loan. However, experienced home buyers know that chances are, you're not going to keep that loan for the full 30 years for various potential reasons. You may want to move after a few years: need for more or less space, new job, marriage, divorce, or simply a desire for change. Another big reason for not keeping the loan full term is refinancing when interest rates drop. Interest rates fluctuate for various reasons by the market and unless you know the future and perfectly timed the market when purchasing your home, interest rates could drop in the future and refinancing your mortgage can lower your monthly payments. You can also refinance your loan for debt consolidation purposes since mortgage rates are typically lower than other loan product rates such as credit card interest rates.

This is where CapCenter offers its greatest benefit because we offer Zero Closing Cost mortgages. The benefit of a Zero Closing Cost mortgage is that once you have the loan you don’t have to worry about holding it to full term unlike typical mortgages with thousands of dollars in upfront costs. You can move for that new job after five years or need for more space before the full loan term (e.g. 30 years). We also monitor the interest rates and share when you should take advantage of refinancing when interest rates drop. In fact, we calculate that you may benefit from our Zero Closing Cost loan product with a refinance every 0.125% drop.  Lenders calculating APR assume you will hold a loan for the full term. If you don’t, the true APR goes up significantly because you already paid the up-front costs for the loan and will not get them back. Realistically, most people refinance their original loans. If you do not have to pay the up-front closing costs, you don’t lose the money when you refinance.

How can I get a better APR?

Interest rates are defined heavily by the markets e.g., federal funds rate, 10-year treasury notes, bonds market, and geopolitics. Freddie Mac publishes the average mortgage rates, which includes the impact of mortgage discount points and upfront fees, on a daily basis. Did you know that CapCenter tracks the industry's average rate with zero discount points and typically meets or beats that average rate, which includes fees?

Understanding that rates are mostly determined by the market with some fluctuations for borrower profiles, e.g. first-time home buyer, income, credit score, etc., you can usually reduce your APR by purchasing mortgage discount points and paying upfront fees to reduce your risk profile without lowering the actual loan amount.

However, please remember that lowering the APR is usually not beneficial for the typical borrower that moves or refinances before the full loan term.

Extreme APR example

Let's examine an extreme example where you need a $100k loan and a lender charges $100k in upfront costs. The amount that you are effectively borrowing is $0 since the lender received the full loan amount as an upfront cost, but you still have a $100k loan that you have to pay off. The minimum amount you need to pay is the $100k in upfront fees + $100k in loan amount with 0% interest (since effective borrowing amount is $0) over 30 years. The published rate for this product can be as low as 3.33% APR regardless of market interest rates. This is assuming that the entire $100k in upfront costs had to be disclosed by the lender as part of the APR calculation. If not, the published APR can be even lower, as long as it includes the legally required fees in the calculation, regardless of market rates.

Considering the average life of a 30-year mortgage is only around seven years, if you move or refinance this loan in seven years, you would still owe a high loan amount to close out the loan. If you had paid the full loan amount $100k as down payment instead of upfront fees, you would owe $0 in loans and have the flexibility to move or refinance any time without sunk costs.

This extreme example shows how you could achieve 3.33% APR even in a high interest rate environment. Realistically, no one would pay upfront costs that equals to the loan amount (otherwise, why would you need a loan?). However, this extreme example shows that you could mix upfront fees to lower the APR of a mortgage.

A real scenario is less obvious than our extreme example, but at CapCenter, we want you to know that we value your equity (e.g. cash and down payment) over upfront fees and discount points, which do not carry over when you move or refinance.

The bottom line

The intention behind APR is good. The goal is to give borrowers a quick way to see hidden fees related to the loan. In practice, however, APR may not actually offer the transparency it is intended to provide especially in the mortgage industry.  

You should avoid making a final decision based just on APR. There are potential flaws in how a lender calculates or represents APR. CapCenter’s Zero Closing Cost loans with published rates and fees allow you to make a great financial decision transparently and move or refinance as needed to save money with increased flexibility.