Why APR is a flawed calculation

APR is a nearly useless calculation with regard to shopping for a mortgage

Every time I go through a set of loan docs with a client, I review the Truth in Lending (TIL) disclosure with them. Part of the TIL is the disclosure of the Annual Percentage Rate (APR) for the loan. The APR is one of the most mis-understood pieces of information for most borrowers, so I have worked and worked on a good way to explain it in layman's terms.

At it's core, the APR is a number that accurately represents the 'total cost of credit' for the loan. A large portion of this total cost of credit number is the amount of interest that is paid over the life of the loan (especially on a 30 year mortgage, since the interest paid over 360 months dwarfs any upfront fees). It also accounts for what are called 'prepaid finance charges'. This includes all of the one time fees associated with obtaining the loan including points, title/escrow, appraisal, recording, etc...

For example, if a loan carries a 5.50% interest rate and has no points and no fees, the APR would be 5.50%. But, if the loan was at 5.50% with 1 point plus $3,000 in other one-time closing costs, the APR would have to include those upfront charges in the total cost of credit and the APR would be something like 5.65% (approximate...it depends on the loan amount).

The theory behind APR is to give consumers the ability to shop various rate and fee options with one consise number (APR). This all sounds great on paper.

Here comes the flaw:

In order for APR to be an accurate reflection of a borrower's best interest (excuse the pun), two assumptions must be true:

1. The borrower keeps the loan to full term and never pays the loan off early and never makes any principal reductions ahead of schedule (including selling the home, refinancing, or simply making extra principal payments to reduce the term).

and

2. The borrower is ambivilent about the cash flow impacts of paying fees upfront out of pocket.

The first assumption is usually the one that is the most flawed.

Statistics tell us that the average time in a home is just over 7 years. The average life of a loan is just under 5 years (between refinances and moving residences).

If we take the 5.50% example from above, I can show you how flawed this becomes when you apply break-even analysis.

The example of 5.50% with no points and no fees vs. the 5.50% with 1 point and $3,000 in fees has a pretty obvious conclusion (take the loan with no points and no fees with the same rate).

However, what if you had the option to take a 5.70% with no points and no fees (APR = 5.70%) vs the 5.50% with 1 point and $3,000 in closing costs (APR = 5.65%).

By strictly looking at APR, one would choose option 2 with the APR of 5.65%, but I could frequently make a case for the higher APR loan being the better option for most people.

What if you were planning on living in the home for 4 years?

Let's do the math:

On a $400,000 loan, the fees on the 5.50% loan work out to $7,000. For this $7,000 you save .20% on the rate every year (on a $400,000 loan that works out to $800/year or $66/month).

It would take 106 months at $66/month to add up to the $7,000 that was paid upfront. In this case, the borrower would have to be pretty sure that they were going to be in the home for almost 9 years for the 5.50% rate with the lower APR to be the correct decision.

But that's not all!

Even if they knew that they were going to be keeping the home for the long term, they still face the risk of rates going down in some time in the 9 years and refinancing before they were able to breakeven on the $7,000 in fees.

Either way, APR doesn't tell the whole story and it is a very flawed number when it comes to shopping for a mortgage.

APR is a lot better when looking at other types of installment credit including auto loans, personal loans, credit cards, and student loans. The reason that APR is better for these types of loans is that refinancing is uncommon and most people tend to keep these loans to full (or close to full) maturity, thus the APR calculation is more accurate.

If you have questions regarding financing (or refinancing) a home, feel free to call me directly.