One of the tools consumers have at their disposal to evaluate competing mortgage offers is the annual percentage rate or APR calculation. The APR is a recalculation of the interest rate factoring in all of the cost associated with a particular loan. Using an APR is valuable because it puts a numerical value on the cost of the loan.

By law, mortgage lenders are supposed to disclose the APR on any mortgage loan. The disclosure is called the Truth in Lending form or TIL for short. Anytime you see an advertisement for mortgage interest rates, you will always see an APR disclosed. Real Estate Settlement Procedures Act (RESPA) mandates that the APR is disclosed because consumers often times do not understand that the lowest interest rate is not always the cheapest loan. Calculating the APR is one way to inform consumers of the real cost of their loan.

Suppose you are evaluating two mortgage loans for $300,000 – Loan A and Loan B. Loan A is a 30 year fixed rate mortgage at 6.375% while Loan B is also a 30 year fixed at 6.5%. Most consumers would jump all over Loan A because it has the lower rate.

What the interest rate alone does not tell you is that Loan A has $6,000 in lender associated fees while Loan B only has $500 in lender fees. The APR on Loan A is 6.566% while the APR on Loan B is 6.516%. Based on the APR, Loan B is the better deal even though it has a higher interest rate.

Even though the lender should supply you with the APR, if you choose to calculate it yourself you will need a financial calculator. A quick internet search will yield all kinds of easy to use APR calculators.

Good Enough For Government Work

While the APR is a great tool for evaluating mortgages, there are some glaring flaws with the calculation that consumers need to take into consideration.

Time: The standard APR calculation on the TIL assumes you will hold the loan for thirty years. As a result, the APR result minimizes the impact of upfront costs. If we reduce the time period to say five years which is more reasonable for many homeowners nowadays instead of 30 in the example above, the APR results are dramatically different. The APR for Loan A is now 7.204% while the APR for Loan B is just 6.570%. Originally, Loan B looked better, but not by much; however, when we adjust for time we see that Loan B is a significantly better deal in the short term.

Only Works on Fixed Mortgages: Because the interest rate on adjustable rate mortgages (ARMs) will change in the future based on an index such as LIBOR, it is impossible to calculate an APR longer than the initial fixed rate period on a traditional ARM. This makes calculating an APR useless and highly inaccurate when dealing with ARMs.

Lack of Standardized Fees: RESPA laws say that lenders should provide an APR on all mortgage loans. However, RESPA does not clearly define what cost items should be included in the APR calculation. As a result, there isn’t any consistency across lender calculations. Therefore, it is imperative you know what fees are included and which are not when comparing the APR of two loans from different lenders lest you are comparing apples and oranges.

If you would like to get a fairly accurate comparison, my recommendation is to simply find an online APR calculator and only include lender associated closing costs (exclude title, prepaid, and other miscellaneous closing fees that are not controlled by the lender) and adjust the length of the loan based on your specific needs. This will allow you to reasonably compare the APR of two mortgage loans.

Overall, the APR is but one consideration when choosing a mortgage. While it is important to get a great deal on a loan, it is also important to choose your mortgage lender based on the overall value being offered in terms of rate, cost, expertise, and reliability. Choosing a mortgage based on rate alone is the biggest mistake consumers usually make when seeking a mortgage. The current mortgage market is changing daily and many loans are not making it to the closing table so it would be wise to focus on reliability more so than cost. Nevertheless, understanding the APR calculation and using it wisely will make you a smarter mortgage consumer.