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. If there are no loan fees and the rate is fixed through the life of the loan, the APR will equal the rate.

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

• 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 is most useful for 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.

In allocating the fees, it is assumed that the loan runs to term. A 30-year loan runs for 30 years, for example, and a 15-year loan runs for 15 years. This is contrary to fact, most loans are paid off well before term. While data on mortgage life are sketchy, the average life of 30-year loans today is certainly below 7 years.

The assumption that loans run to term reduces the fees allocated to each month, reducing the APR relative to what it would be if the loan was paid off before term. This imparts a bias in favor of loans with low interest rates and high fees.

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.

For example, a borrower has a 7.5% mortgage with balance of $160,000 and needs to raise $20,000. The rate on a cash-out refinance for $180,000 is 8%, and if there are no fees, the APR is 8%. The rate on a second mortgage of $20,000 is 9% and if there are no fees, the APR is 9%. A comparison of APRs suggests that the cash-out refinance is cheaper, but it isn’t. The APR of 8% does not account for the 1/2% increase on $160,000 which would be avoided by selecting the second mortgage.

To make it comparable to the APR on a second mortgage, the APR on the cash-out refinance must be converted into a "net-cash APR". A net-cash APR compares the difference in payments between the old and new loan to the amount of cash received by the borrower. It thus takes account of the difference in rate between the old mortgage and the new one.

But this will not happen anytime soon. Meanwhile, the best way to avoid going astray is to use calculator 3d (Cash-Out Refi Vs Second Mortgage). The calculator compares all the costs over a future period of the existing loan plus a second with the costs of the new cash-out refi. It also shows the "break even" rate on the second, which is the highest rate you can pay on the second and come out ahead of the cash-out refi.

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

A HELOC is a line of credit, as opposed to a loan for a specified sum, and it is always adjustable rate. The interest rate on all HELOCs is equal to the prime rate plus a margin, and the rate adjusts the first day of the month following a change in the prime rate. If the HELOC has an introductory guaranteed rate, any rate adjustments are deferred, but typically guaranteed rates hold for only a few months.

The critical price variable is the margin, but that is not a required disclosure. The APR is a required disclosure, but it is defined as the interest rate, which can be well below the prime rate plus the margin. That makes it a useless redundancy. Borrowers shopping for a HELOC should ask for the margin.

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. It is assumed that rate index used by the ARM stays the same for the life of the loan. This is called a "no-change" or "stable- rate" scenario.

Here is an illustration from June, 2006. A 7/1 ARM that uses as its index 1-year Libor had an initial rate of 6.25% with zero points. The value of the index at that time was 5.426% and the margin was 2.25%, summing to 7.676%. The APR is 6.912%, based on 6.25% for 7 years, and 7.676% for the remaining 23. The rate adjustment cap of 5% did not figure in the calculation because the rate increase was smaller.

The APR on an ARM thus takes account of the initial rate and period, the current value of the rate index, the margin, and rate caps. Borrowers often don’t have this information, or don’t know what to do with it if they do have it. This makes the APR on an ARM a useful piece of information, provided that the borrower intends to have the mortgage at least 7 years, and that the ARM is not a HELOC.

But there is one proviso. The APR on an ARM assumes that the rate index stays at the initial level through the entire life of the loan. In general, this is the single best assumption you can make, since no one can predict interest rates years in advance. However, when interest rates are as low as they have ever been, as in 2003-2004, there is much more scope for a future increase than decrease. There is a limit on how low rates can go, but no limit on how high they can go. Under these circumstances, I would be hesitant about comparing the APR on an ARM with that on a FRM.