01Get the Wrong Mortgage by Comparing APR
If you're getting a mortgage, it's a good idea to shop around for the best deal. But how do you compare lenders? Borrowers typically look at the Annual Percentage Rate (APR) of each loan and choose the lowest one. That strategy makes sense in theory, but it can lead you down the wrong path.
Is APR a valid comparison tool? Only if you compare apples to apples – which is a challenge.
Lenders have some wiggle room when they calculate APR for you. They may or may not include some of the costs you’ll pay. For example, the credit report fee, appraisal fees, and inspection fees may not be included in your APR quote. Since different lenders can charge different credit report fees, the APR comparison becomes less valuable.
An honest lender will include more fees that accurately reflect your circumstances, which makes their APR appear higher.
- See Manage Your Closing Costs for information on these fees
Bait and Switch With APR
When looking at advertisements, APR can be deceiving. Websites might show attractive APRs much lower than those you’ve come across. Keep in mind that you may not qualify for those rates.
An advertised APR may not include mortgage insurance costs. If you’ll need private mortgage insurance (PMI), the APR is going to increase. Likewise, those APR quotes are for the best borrowers out there. If you have less-than-perfect credit or you need a low documentation loan you’ll have a higher APR.
Does APR Assume a Long Term Relationship?
When you see a loan’s APR, you assume that the loan will be paid off over its entire lifetime. For example, the APR on a 30 year loan is calculated with the assumption that you’ll keep the loan for 30 years. In reality, most people do not keep their loans alive that long. 7 years or so is more like it.
If you pay off a 30 year loan after 7 years, APR will lead you down the wrong path. You’ll see lower APRs on loans with high up-front fees and lower interest rates. Unfortunately, you won’t be able to spread the up-front costs you paid over very many years.
If you pay your loan off early, the actual APR is higher than what you see quoted. APR is most useful if you plan to keep the loan forever.
02How APR Fits in the Big Picture
Keep in mind that getting the lowest APR doesn’t mean you’re doing the best thing for your overall financial position. Look at the big picture as well.
For most borrowers, APR makes the loan with a lower rate and higher up-front fees look best. However, this means you’ll have to come up with thousands of dollars today. You might benefit from lower monthly payments over time, but is it worth it?
You’ll know the answer if you look at the big picture. Looking at your breakeven point can help, and other factors matter as well. Could you put the few thousand dollars of up-front costs into an IRA or retirement plan instead and come out ahead? Is an extra $100 per month on your payment going to matter that much in 5 or 10 years? Again, are you going to keep the loan long enough to recoup those costs?
By looking at the big picture you have a better chance of doing the right thing.
03A Better Way
Focusing solely on APR, which is nebulous and perhaps deceptive, is not the best way to shop for a loan. Sure, it’s better than a sharp stick in the eye if you cannot or will not take the time to look under the hood. However, there has to be a better way.
If you want to find the best loan, take a look at each lender’s quote closely. Look at the rate and closing costs – not just the APR – and note carefully which costs are excluded. Build a little spreadsheet to get an apples to apples comparison. If you want to, run your own numbers with our APR calculator.
You can also lean on your lender to help you wade through APR comparisons. Ask each of them “how is your loan better than the other guy’s?” Show them the loan estimate or good faith estimate (GFE) and ask them to help you understand.
APR can be confusing. To learn more about different types of APR, see What does APR Mean?