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By September 29, 2014 1 Comments Read More →

Why The Mortgage APR Is Too Low

1910 Brunsviga mortgage calculator. From the collection of Peter G. Miller.

The mortgage APR is generally higher than the nominal interest rate but is it high enough? The answer is “no” and here’s why:

One way to look at the APR — the annual percentage rate — is to have an interest level of 4.2 percent and points and fees of $5,000. In this situation — which is open to debate as we shall soon see — the rough APR is 4.63 percent. How did we get the APR? Think about it this way: $100,000 less $5,000 in points and fees means we really borrowed $95,000.

The APR is intended to help borrowers better understand the cost of possible loan choices and provide a way to quickly and easily compare mortgage offers. According to the Federal Trade Commission, the “APR takes into account not only the interest rate but also points, broker fees, and certain other credit charges that you may be required to pay, expressed as a yearly rate.”

Mortgage APR Versus Loan Length

Generally, to compute the APR you first have to look at the interest rate, the 4.2 percent in the example. Then you add related fees and divide by the length of the loan.

Yet — unfortunately — this calculation doesn’t work in virtually every case. Here are two reasons why:

First, notice what the FTC said in its APR definition. “Certain” fees are used to figure the APR — but not all fees. The fees used in our example — $5,000 — may exclude given expenses. This means the apparent APR might not reflect all loan costs.


Second, the APR is computed over the potential life of the mortgage, say 30 years. Now go back to the $100,000 mortgage at 4.2 percent interest with $5,000 in fees and charges. The APR was 4.63 percent over 30 years. However, according to Freddie Mac the typical loan is outstanding just 7.4 years and not 30 years.

Using a realistic loan life radically changes the potential cost of the loan.

The Mortgage APR Corrected For Years

The real cost of the $5,000 in expenses should be measured over 7.4 years and not 30 years.

If we have a $100,000 loan at 4.2 percent that we pay off in 89 months (about 7.4 years) the monthly payment will be $1,310. If the loan amount is reduced to $95,000 and the monthly payment is the same then the interest rate is 5.66 percent

There’s no doubt that 5.66 percent is a lot different from 4.2 percent. There’s also no doubt that lenders understand this.

What does this mean to the borrower? Think about how long you will likely own the home. It could be very much in your benefit to get a higher interest rate in exchange for fewer points and lower fees up front if you expect to be a typical owner.

Also, in addition to the APR, ask lenders to quote the “par” rate for any mortgage offer — that’s the interest cost without points.

(Originally syndicated to newspapers nationwide by Content The Works and expanded and updated for OurBroker.com)

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1 Comment on "Why The Mortgage APR Is Too Low"

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  1. David Reed says:

    Peter- I’ve always been a fan of low/no closing costs with an adjustment in rate. Agree completely with your post.

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