Is APR the best tool for shopping mortgage rates?

APR was created by our government to help consumers select a mortgage or other loan interest rate. It was intended to be a tool that would allow someone to simply compare various loan scenarios and shop lenders for the “best rate” at the lowest cost. Unfortunately, APR is probably not providing an accurate view of what the true cost of the loan is, whether it’s for a home purchase or refinance.

It’s widely known that APR is easily manipulated. You could probably ask ten different lenders to provide you quotes at the same rate and same cost, and receive ten different APRs. Sometimes it may be an accident, a mortgage originator forgets to factor in an escrow fee or private mortgage insurance premiums, and sometimes it’s not. For example, there are plenty of misleading ads on the internet (and other media) where APRs are an obvious bait and switch tactic for mortgage lead generating companies.

Some loan operating systems (LOS), tools that mortgage originators use to originate and process loan applications, have built in defaults that prevent APR from being correctly quoted. Some do not factor rate rebate credit towards the closing cost when calculating the APR.

This means that if you price out a refinance with a rate that has enough rebate credit to pay all closing cost, the APR would be the same as a refinance without any rate rebate. It’s erring on the side of side of the consumer, however, it’s not accurate and if you’re relying on APR and looking for a mortgage rate quote with rebate pricing, you might not select a quote even if the net cost are lower.

Despite our government’s good intentions, the system is flawed. What can you do?

The only way you can truly select a mortgage program when considering the cost of a mortgage rate is to compare the rate to the net cost. When pricing a mortgage rate, it either has discount points, which buys the rate lower OR it has rebate credit reducing closing cost, which is caused by having a slightly higher mortgage rate.

In this example, we are using a rate term refinance with a loan amount of $190,000 for home owners with excellent credit and a loan to value under 60%. Closing cost (includes title, escrow, appraisal and lender fees – not including prepaids or reserves) are estimated at $2880.

  • 2.500% with an apr of 2.768% has a discount (cost) of $1115. The net cost of this rate is the discount plus the closing cost = $3995 ($1115 plus $2880). Principal and interest (P&I) payment is $1,266.90, dropping their mortgage payment by $260 per month.
  • 2.750% with a disclosed apr of 2.936% has a rebate credit of $925 reducing the closing cost for this rate to $1955 ($2880 less $925). P&I=$1289.38, reducing their mortgage payment by $238 each month.