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.
Casey Bond is the Editor-in-Chief for www.GoBankingRates.com, your source for the best CD rates, savings account rates, personal finance news, and more.