When shopping for home loans, borrowers are usually most concerned with
the annual percentage rate (APR) offered by a mortgage lender, rather
than simply the interest rate, since the APR is meant to provide a more
complete picture of how much a loan will truly cost. After all, APR
calculations take into consideration all of the fees associated with
loans, in addition to mortgage interest rates, which makes finding the
best mortgage really easy; the lower the APR, the better the deal—right?
Not so fast.
Yes, it's true that the APR on a home loan is a more comprehensive
representation of how much that loan will cost you year-over-year.
However, you should not trust the APR alone for an accurate
understanding of it's true cost. Why? There's no standard governing
which fees have to be included in an APR, essentially allowing lenders
to choose what goes into the calculation, and what doesn't. Not to
mention, the calculation itself is based on a number of assumptions that
often don't hold true.
That's why when choosing a lender to finance your home purchase, your
ultimate decision should not be based on the APR alone. Learning to
scrutinize a mortgage lender's fees is crucial in avoiding being duped into paying excessive charges for a mortgage.
What Does "Annual Percentage Rate" Mean?
In the case of a mortgage, the annual percentage rate, or APR, is the
total yearly cost of financing a home, expressed as a percentage of the
amount financed. So for instance, say you are quoted a mortgage APR of
3.8 percent—that means if all the interest, points, and any other
closing costs were added up, and then that sum was spread evenly across
the entire loan term, annual payments on that total would equal 3.8
percent of the original loan amount.
It may seem a bit complicated, but the federal government actually
began requiring lenders to provide an annual percentage rate alongside
any advertised interest rate in order to simplify the process of home
loan comparison shopping. A result of the Truth in Lending Act, the
requisite to provide an APR is meant to give potential borrowers a more
comprehensive benchmark by which to compare mortgages. Unfortunately,
that goal is often not met.
Why the APR Can be a Misleading Number
Examining several APRs in search for the most affordable mortgage may
not always be an apples-to-apples comparison. The problem is that there
is no standardization of what is to be included in the APR calculation.
Lenders may choose to include some fees as part of the APR, while
others are kept separate, and third-party fees like title and appraisal
fees are always left out. Plus, while there are some typical settlement
charges that don't deviate much in cost (like taxes), other closing
costs vary from lender to lender, and the APR gives no indication as to
which charges are negotiable or simply too high.
Additionally, closing costs are amortized over the entire loan term.
The APR is calculated on the assumption that you won't sell your home
before the mortgage is fully repaid, pay the loan off early, or
refinance, and doesn't take inflation into consideration at all. And if
you're obtaining an adjustable rate mortgage, the APR is a truly
meaningless number because you can't predict what the future interest
rate will be once the loan resets.
The Best Way to Evaluate Mortgage Costs
This is not to say that the annual percentage rate is not a useful
number for comparing
mortgages—the APR is a good starting point for
narrowing down potentially attractive offers. However, because it's not
always the most accurate representation of a mortgage's affordability,
it's important to learn how to dig deeper and really understand the true
cost of any loan before committing.
Whenever you are quoted an APR on a mortgage and you're serious about
pursuing that offer, ask to see the lender's Good Faith Estimate (GFE).
The GFE is a list of all the fees that would be charged to provide you a
home loan, including the charges that would otherwise not be included
in the APR. Lenders are required to provide this information without any
commitment from you.
Keep in mind that it is an estimate, and total charges may end up a
bit higher or lower at closing. Even so, the GFE will let you view all
fees, item by item, and identify any instances of overcharging or "junk
fees" the lender may try to slip past you.
A home loan is probably the biggest financial liability you'll ever
take on in your lifetime, so make sure you aren't paying any more than
necessary. It's easy to be wooed by low rates, but know that an offer
that seems too good to be true probably is, and you have the ability to
find out for sure.
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