Aaron Brown with Box Home Loan talks about what you need to know about your APR.
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Lawmakers and regulators are fond of creating new disclosure documents each year for mortgage consumers.
These disclosures are designed to protect borrowers from the few bad apples in the mortgage industry.
Ironically, the more disclosure documents that lawmakers create, the less likely borrowers are to read any of those documents. The mammoth stack of disclosures has only complicated things. In fact, some of these disclosure documents that were intended to inform and educate consumers actually end up confusing them. Such is the case with the Federal Truth-in-Lending disclosure, particularly its most important calculation—the Annual Percentage Rate (APR).
Few figures are more critical in helping you shop for the best deal on a mortgage. Yet, the APR is both the most misunderstood and the most misrepresented number in the disclosure packet. First, I will define A.P.R in very simple terms. Second, I will explain how the best APR is not necessarily the best deal. Finally, I will address why sometimes you shouldn’t trust the APR you are quoted.
A Simple Definition
Let’s keep this real simple. The APR is supposed to tell us what it really costs to borrow money. When we borrow money for a home, we typically pay closing costs in addition to paying interest to the lender. The APR weighs the closings costs and the interest rate we pay to calculate the true cost of the loan. Consider the following example. Imagine that you borrow $100 for one year at an interest rate of 10%. In order to process your loan, the lender also charges you a $5 fee. At the end of the year, you would have paid $15 to borrow the money: $10 in interest and $5 in fees. That means that your APR would be 15%.
An APR will generally be higher than your interest rate*, as in the example above. That’s because it adds your closing costs on top your interest rate to tell you what it really costs to borrower money.
Thus, the closer your APR is to your interest rate, the better the deal you are getting. However, be careful because a low APR can deceive you as well.
The Best APR is Not Always the Best Deal
If you take one thing from our discussion, let it be this: the lowest APR can sometimes be the worst deal for you. APR can be deceiving because it calculates the average cost of your loan over 30 years.
However, if you end up keeping your loan for only 5 years, then the loan ends up costing you much more than what the APR originally disclosed. Is your head spinning yet? Let me simplify it again with some easy math. Remember that the APR calculation takes the closing costs you pay and averages that cost over 30 years. So, if you pay $3,000 in closing costs for a 30 year loan then you have just paid an average of $100 per year ($3000 divided by 30 years**) to get your loan. That average cost of $100 per year is added to the interest that you pay each year to determine your true financing costs, or APR.
Now, if you pay $3,000 for a 30-year mortgage, but you keep the loan for 5 years, then you have effectively paid an average of $600 per year in closing costs. My point: don’t look for the lowest APR to determine which loan is best for you. Instead, make an educated guess of how long you are going to keep the loan, and then select of a combination of interest rate and closing costs that appeal to you.
Once you have selected that combination of interest rates and fees, then you are able to use the APR to your advantage.
The real point of the APR is to let you easily shop the same interest rate with two different mortgage companies. Each company should quote you an interest rate with its accompanying APR. All you have to do now is compare each company’s APR for the same interest rate. Whoever has the lowest APR wins—well, sort of. Even then, there are some problems with what should be a simple process.
Buyer Beware: The Problem with APR
You’ve heard the saying, “Garbage in, garbage out.” That’s the first problem with APR. calculations. The correctness of an APR depends on what data each mortgage company includes in the calculation.
Government regulators—in their infinite wisdom—decided that certain closing costs were to be included in the APR and certain fees were not. For example, an appraisal fee is not included in APR. The same goes for title insurance. But the “closing fee” you pay to the title company is included, while your county recorder’s fee is not. Why this is so is one of the great mysteries of the universe. I can think of no rational reason for this somewhat arbitrary way of calculating the true cost of borrowing money.
Because not all fees on your Good Faith Estimate are included in your APR, mortgage companies must manually input into their lending software which fees should be calculated in the APR. And amazingly, many mortgage companies—typically small brokers (which make up a majority of the mortgage market)—leave that process up to each individual loan officer. Often that loan officer doesn’t really know what should and shouldn’t be included in the APR. A few even deliberately exclude fees from the calculation to make their APR look better.
The second problem with the APR is really the opposite of what I just mentioned. Sometimes an APR is overstated (i.e. higher than what it really is). Consider the following. Most of the loans that we close at Box Home Loans include credits or rebates that we give to our customers to help offset some of their third-party fees. For example, recently our website displayed closing costs of $1,101 for a $300,000 loan amount. That amount included third party closing costs of $1,923, which was in part offset by a credit from us of $822.00, making the net closing costs $1,101. While our website calculates the rebate that we give to the customer in the APR calculation, many of our lending partners’ software wasn’t programmed to calculate negative numbers or rebates. Thus, the APR on our website and Good Faith Estimate differs from the APR on our final closing documents prepared by our lending partners—even though the fees disclosed on the Good Faith are exactly the same as the fees disclosed on the final settlement statement.
Keep It Simple, Stupid
In conclusion, I recommend that you heed the advice of my childhood tennis coach, “Keep it simple, stupid.” Sometimes we make all of this too complicated. When you shop for a mortgage, you should definitely compare APRs from different companies. However, the easiest way to make sure that you are getting the best deal is to keep it very simple. When you compare Company A to Company B, narrow your comparison to each company’s fees for the same rate. This is critical.
Also, when you compare fees, remove all the third party fees from your comparison***. Those are fairly standard fees that will be the same no matter where you get your loan. If you are uncertain about which fees to remove from the analysis, know that almost all Good Faith Estimates uniformly number each fee. The title-company related fees are numbered 1100 through 1199. The appraisal fee is number 803.
Everything else is most likely a lender’s fee.
Lender’s fees are typically numbered 800-899 (appraisal excluded).
These include points, processing fees, underwriting fees, admin fees, application fees, tax service fees, flood certifications, etc.
Our lack of lender fees is why our APR’s are so low, and why Box Home Loans is so amazingly competitive. The only time our lender fees exceed $95 is when our clients choose to pay points to buy down their interest rate. Our lack of fees makes the process of comparing us to others that much easier. That’s one more reason why it’s better to fit inside the box.
*An APR can be lower than its corresponding interest rate if the cost of the rate is less than zero. For example, you will notice on our website that certain rates not only cost nothing, but that they actually give you rebates or credits beyond the cost of the third party fees. In those instances, an APR would be less its interest rate.
**Assumes a 30 year loan. Likewise, it is calculated over 15 years if it as 15 year loan.
***On occasion, lenders will choose to pay some for an appraisal or another third-party fee to make their quote more competitive. This should definitely be considered in your evaluation.
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For more information on your APR, go to www.boxhomeloans.com
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