What is Annual Percentage Rate (APR) and How Should I Use This Information?

By Gina Pogol
Mortgage Credit Problems Columnist

Mike Asks: Dear Gina, I am trying to refinance my mortage and have been shopping carefully. Each lender gives me a Truth-in-Lending disclosure, which shows my interest rate and an APR. What am I supposed to do with this?

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Gina Says:

Dear Mike,

APR, or Annual Percentage Rate, is one of the most misunderstood concepts in mortgage lending. It's supposed to make shopping for a mortgage and comparing different loans easier. So, how's that working out for you?

The problem with APR is that it's really better designed for comparing credit cards or other short-term debt. If you are refinancing your mortgage, APR can help you get the best loan, but you have to understand it and work within its limitations.

Putting APR to Good Use

Here is an example of how you might use APR when comparing two $200,000 mortgages. One costs two points plus $2,000 and carries an interest rate of 4.75%. The other loan costs nothing and carries a rate of 5.125%. Which loan is the better deal? APR incorporates not just the mortgage's interest rate, but also its costs, and expresses that as an interest rate for easy comparison. In this case, the 4.75% mortgage has an APR of 5.01%. The 5.125% loan's APR is 5.125%, because it has no costs. So is the loan with the lower APR always the right choice? Not necessarily.

Mortgage Refinancing and APR: When You Assume....

APR calculations make some assumptions that just don't hold true, and one of those is that you will keep the loan for its entire term. Most people don't do that, and almost no one with a bad credit mortgage would do that--those loans are for fixing bad credit, then you refinance to better terms as soon as possible. Many bad credit lenders offer no-cost loans, and you should consider these if you don't qualify for prime financing. The more fees you pay upfront, the longer you have to keep the loan to make the lower rate pay off. So, back to our example--what happens to that 5.01% APR if you only keep your loan for 15 years? It jumps to 5.20%! And it's no longer the better deal.

So, use the APR calculation when shopping for a mortgage refinance. Just understand that it can't be the only thing that drives your decision. APR can only be used to compare the same kind of loans--you can't compare a 30-year fixed mortgage to an ARM. And, if APRs for two loans are similar, and you don't plan on keeping the loan forever, take the one with the lower upfront costs.

Good luck with your refinance and thanks for writing.

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