Why is the APR lower than the advertised mortgage rate?

By Gina Pogol
Mortgage Credit Problems Columnist

Dear Gina, I'm a first-time buyer with credit problems, and I'm confused. My realtor told me that the annual percentage rate (APR) is always higher than the advertised mortgage rate. Then she said I should compare quotes from bad credit mortgage lenders and pick the one with the smallest APR. But some loans have APRs that are lower than the stated rate! What do I do now? - Brooke, Spokane, Wash.

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Dear Brooke,

A loan's APR, or annual percentage rate, can be higher, lower or equal to its stated rate. The APR is based on your loan's interest rate and its costs. APR is just another way of describing your loan -- you can say, "This loan is 5 percent at a cost of 2 points," or you can say, "This loan has an APR of 5.17 percent." APR makes it easier to compare loans with different rates and costs.

For a fixed-rate mortgage that is not a no-cost product, the APR is always higher than the stated rate. For a no-cost fixed-rate loan, the APR should equal the stated rate.

One cost that you might overlook is mortgage insurance. If you purchase with less than 20 percent down or refinance with less than 20 percent home equity, you'll probably have to buy mortgage insurance. The cost of that should be included in a valid APR calculation.

Calculating APR on adjustable-rate mortgages

Adjustable-rate mortgages (ARMs) make APR calculations more complicated. You still have an interest rate and costs, but the rate may change over the life of your loan. The APR calculation accounts for that -- sort of. Even though the rate adjusts in the future, the APR calculates the future rate as though it were resetting today.

For instance, an ARM might have a start rate of 4 percent which will reset in three years, according to the loan's terms. A typical reset might be, the 6-month LIBOR index plus 1.5 percent. If in three years the LIBOR is 5 percent, the new rate would be 6.5 percent. But if today, when the APR is disclosed, the LIBOR is only 0.71 percent, the APR calculation incorporates a 2.21 percent rate (0.71 percent plus 1.5 percent). That makes the APR lower than the 4 percent advertised rate.

Although it's unlikely that your 4 percent ARM would reset to 2.21 percent and stay that way for 27 years, that's the assumption that the APR calculation is based on for ARMs.

How to think about the APR

APR has its limitations, but it can still be useful for mortgage shopping. Understand that it changes depending on your loan type, fee structure and even how long you plan to keep your home. A good loan professional can help you choose the loan with the lowest cost, given your parameters. However, don't put that decision in the hands of an untrained financial advisor like a real estate agent.

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