Why APR is Worthless.

Do you know what APR is?

Do you know why it is higher than your interest rate?

Do you know why you should ignore it?

If you donâ??t know the answers to these questions you donâ??t have a good understanding of youâ??re mortgage. When you donâ??t have a good understanding, youâ??re not in control of your mortgage â?? and when youâ??re not in control you have a good chance of ending up with a Blown Mortgage.

What is the APR?

APR stands for Annual Percentage Rate. It is the calculation of your true cost of borrowing the money for your home loan over the life of the loan. It is supposed to make comparing loans an â??apples to applesâ?? proposition. Because there are so many different loan terms, repayment schedules, and loan types; it is often hard to compare them side by side and make the determination â??Which one is the best deal.â?? The APR is supposed to solve the comparison problem and answer the better deal question all in one fell swoop.

When calculated correctly the APR will tell you which loan scenario has the highest â??effectiveâ?? interest rate over the life of the loan. This is done by taking the amount of money borrowed, plus all of the fees and expenses associated with the loan and calculating an interest rate based on paying back all of those combined monies over the life of the loan.

You can find your APR on the Federal Truth In Lending disclosure you receive from your lender.

Why is it higher than my interest rate?

Gasp! Your loan originator is lying to you! They told you one rate and then they bait-and-switched you in to a higher rate, and thought they could get away with it! Errr, hold the complaint to the Better Business Bureau for right now Sparky. They werenâ??t lying to you about your interest rate â?? and nothingâ??s changed. The APR is not the interest rate of your mortgage note. But you say, it looks a lot like my interest rate; itâ??s close to the number and has a % sign next to it â?? and itâ??s higher!!!

The reason the APR is higher is that it takes in to account the fees associated with your mortgage and then recalculates the cost of the total amount of money over the life of the loan. The interest rate of your mortgage doesnâ??t take in to account the costs of getting the mortgage â?? and thatâ??s where the difference is.

So why do they make it so confusing â?? why give me two rates, when all I really care about is my interest rate?

We give you two rates, the interest rate and the APR because it is supposed to help you compare loans side by side that may have very different characteristics. Get it? No? Whatâ??s a better loan? A 7 year fixed at 5.125% and 4 points closing costs or a 30 year fixed at 5.5% and 1 point closing cost? How about those two loans compared to a 2 yr fixed at 5.25 with 2 points in fees and a 2 point loan discount fee?

If I was rate sensitive I might think that I should always take the 5.125% because it â??has the lowest interest rateâ?? when in fact the 30 year at 5.5% may be cheaper because of the fewer points. It is almost impossible to calculate this on the fly. You can quickly see how looking at different loans and comparing them can get complicated. The APR is supposed to solve that problem.

Hereâ??s an example from Bankrate.com:

For example, you might get the following two quotes for $150,000 mortgages, each for a 30-year term:

Lender A offers 6.5 percent with the borrower paying no discount points and $5,000 in fees;

Lender B offers 6.25 percent with the borrower paying 1 discount point ($1,500) and $5,500 in fees, for a total of $7,000 in points and fees.

Lender B offers a lower interest rate (or "nominal rate"), but for $2,000 more in points and fees.

Which is a better deal? APR gives you a general idea.

Lender A’s offer has an APR of 6.83 percent, while Lender B’s offer has an APR of 6.71 percent. Since Lender B’s APR is lower, that loan is a better deal in the long run.

That is how APR works. Note this does not mean that more fees up front means a better deal â?? FAR FROM IT! It just means that you have to look at the entire picture of the loan, and not just one aspect of it to determine which loan is best for you.

Now hereâ??s why I believe you should IGNORE the APR when comparing loans.

The APR is easily manipulated. Any broker or lender can make the APR look lower than it actually is by leaving some of the fees out of the calculation. Itâ??s just as bad as the GFE, except it takes less work to change. At least on the GFE there are lots of areas to leave blank.
The APR really only works over the long run, as in the full term of the loan. Using the Bankrate.com example above, say you are only in the loan for a short period of time. If the loan that costs more in terms of real cash has a lower APR (Lender B), who cares? Youâ??re not going to be in the loan long enough to reap the benefits of paying that additional cash up front for a lower APR. That money could go towards something of true benefit â?? not of saving you money that youâ??ll never end up spending.
Brokers donâ??t need to disclose APR. The Federal Truth In Lending disclosure is only required to be disclosed by lenders, not brokers. If you get an APR quote from a lender and compare it to an interest rate quote from a broker, you are looking at two different things and are clearly very confused.
While the APR idea is good in theory there are just too many variables for it to make much sense as a guide post for choosing a loan. As Iâ??ve said numerous times in the past; find someone you trust, shop multiple offers, and educate yourself on the process.

So thatâ??s why I dislike APR. It is once again a measure that is too easily manipulated to present a false picture of the loan. There are ways to compare loans â?? but APR to APR is not the way to do it.

If youâ??re considering a new loan and are confused about the APR vs. interest rate issue, send me an email and Iâ??ll be happy to explain it to you, for as long as it takes, until you get it. And I wonâ??t even try to sell you a loan from me.

UPDATE: The XBroker has an excellent post on the topic.