Questions About the Annual Percentage Rate (APR)

June 19, 2006, Revised January 3, 2008

What is the APR?

It is a measure of the cost of credit that includes loan fees paid to the lender upfront, as well as the interest rate. The higher are the loan fees, the larger will be the APR relative to the rate. For the logic underlying the calculation, see Annual Percentage Rate Simplified.

What is the Purpose of the APR?

To provide a single comprehensive measure of the cost of credit to borrowers, which they can use to compare loans of different types and features, and loans offered by different loan providers.

The APR is a mandated disclosure under Truth in Lending. (See Does Truth in Lending Help Borrowers?) Mortgage shoppers confront it as soon as they search for interest rate quotes, because the law requires that any rate quote must also show the APR.

Can All Borrowers Rely Safely on the APR?

No, most borrowers should ignore the APR, including:

Borrowers who expect that they will sell their house or refinance the mortgage within 7 years.

Borrowers looking to raise cash, who are comparing the cost of a cash-out refinancing with the cost of a second mortgage.

Borrowers with little cash who need a high-rate loan with negative points (rebates) to cover their costs.

Borrowers shopping for a home equity line of credit (HELOC).

The APR may be useful to borrowers shopping for an adjustable rate mortgage (ARM), who expect to hold the mortgage a long time, and who are not doing a cash-out refinance, a low or no-cost mortgage, or a HELOC.

Why Should Borrowers Who Expect to Have Their Mortgage Less Than 7 Years Ignore the APR?

Because over short periods, the APR is biased in favor of loans with low interest rates and high fees.

The APR is calculated on the assumption that loans run to term. This reduces the fees allocated to each month, reducing the APR relative to what it would be if the loan was paid off before term, which most of them are.

For example, in shopping for a $200,000 30-year fixed-rate loan, Jones is offered 7% with $5500 in fees and APR of 7.28%, versus 6.5% with $11,500 in fees and APR of 7.08%. A comparison of APRs suggests that the 6.5% loan will cost less.

However, if Jones sells the house or refinances after 7 years, the APRs calculated over 7 years would be 7.53% for the 7% loan and 7.61% for the 6.5% loan. The conclusion regarding the least costly loan is reversed.

Why Should the APR on a Cash-out Refinancing Be Ignored?

Because it fails to take account of the rate on the old mortgage that is refinanced.

If the rate on the old mortgage is below the rate on the new larger mortgage, failure to account for the loss of the lower rate can falsely suggest that the cash-out refinance will cost less than a second mortgage that raises the same amount of cash. See The APR on a Cash-Out Refinance.

Borrowers comparing the cost of a cash-out refinancing with the cost of a second mortgage should use a calculator that takes account of the loss of the existing mortgage, such as my 3d, Mortgage Refinance Calculator: Cash-Out Refi Versus Second Mortgage.

Why Should the APR on a High-Rate/Negative Point Loan Be Ignored?

Because there is no clear rule regarding the treatment of negative points in the APR calculation. Different lenders do it in different ways, which means that their APRs are not comparable. See Annual Percentage Rate Below Interest Rate on FRMs?

Borrowers who need a rebate to cover some or all of their settlement costs should shop for the largest rebate at a specified rate, or shop for the lowest rate on a no-cost loan. See No-Cost Mortgages.

Why Is the APR on a HELOC Not Useful?

Because the APR on a HELOC is the initial interest rate, which the borrower already knows.

Borrowers should shop the margin, which is the amount that is added to the prime rate to determine the HELOC rate after the introductory rate period is over. See How Do You Shop For a HELOC.

Why Is the APR on an ARM a Useful Measure For Borrowers With Long Time Horizons?

Because the APR calculation on an ARM takes account of important ARM features that the borrower often doesn’t know or understand.

The APR calculation on an ARM uses the initial rate for as long as it lasts, and then uses the current value of the rate index used by the ARM, plus the margin, subject to any rate adjustment caps. This makes the APR a useful summary measure for borrowers with long time horizons, or for any borrowers when lender fees are about the same. For further detail, see Annual Percentage Rate Below interest Rate on ARM?

Copyright Jack Guttentag 2008