Comparing mortgages of different types and maturities is a time-consuming and tiresome task. However, it is vitally important to reduce home costs by having a measure of comparison between mortgage types. The mortgage APR tool is a simple but important measure for understanding home financing requirements.
What Is the Mortgage APR?
The mortgage APR or annual percentage rate is the annual cost of a mortgage determined in the following fashion: Take the principal amount to be borrowed and subtract all those expenses relating to the purchase of the property. This includes points paid at the time of closing, appraisal, credit reports, processing and any other local or miscellaneous fees. The coupon rate of the mortgage is the discount rate, and the original mortgage amount is the principal. An example follows.
Presume a mortgage of $100,000 due in 30 years with a 5 percent rate. All associated fees total $1,500. Using the calculator provided at mortgagefit.com, the annual percentage rate is 5.1312 percent.
The purpose of the APR is to compare any mortgage—30-year mortgage, 15-year mortgage, 5-year adjustable-rate mortgage, extra payment plans, bimonthly plans—on a similar basis. Generally, the APR achieves its intent except for some issues noted below. Home buyers are sometimes confused by the fact that costs are subtracted from the mortgage amount. This was done so that all relevant costs are taken into account. Clearly, the home buyer who funds the expenses from his or her pocket will have a lower APR than the home owner who funds the start-up costs with the mortgage. It was decided that all relevant costs would be included if they were necessary to the home purchase regardless of how they were paid.
The interpretation of the APR has a few nuances to be appreciated. A 15-year mortgage and a 30-year mortgage with the same associated costs will create an APR advantage to the 30-year mortgage. This is only because the 15-year mortgage is repaid faster. A rule of thumb in this case is that the APR rises about one-tenth of a percent. This will always happen when a longer-maturity loan is being compared to a shorter-term loan. Usually the shorter maturity demands a lower interest rate, and this will offset the maturity effect.
Computing the total term of a loan is impossible with a variable-rate loan since the loan's future rate is not known. The consumer can make some assumptions as to what rates may be in the future and blend the results with the computation from the known term of the variable rate. It is important for the investor to remember that the costs of refinancing a variable-rate mortgage result in two sets of associated costs and thus raise the true cost of the variable-rate financing.
The computation of mortgage costs is complex. As a cash flow measure, for example, it is better to pay a 30-year mortgage off with additional payments (assuming there is no prepayment penalty) rather than be forced to make the heavier payment schedule of the 15-year term. However, APR will be higher with the more liquid 30-year mortgage. APR cannot be the only determinant of the home buyer's decision, but it is the single most important tool to use when comparing mortgages.