Are You Confused About APR?  You're Not Alone!

Question: I am considering refinancing my $300,000 mortgage and cannot decide whether or not I should buy the rate down with points or take a higher rate and pay zero closing costs. My loan officer gave me two options. He said I could refinance to a 30-year fixed rate of 5.25 percent with total fees of $13,000 or I could refinance to a 30-year fixed rate at 5.875 percent with zero fees. The Annual Percentage Rate (APR) on the 5.25 percent loan is 5.624 percent. The APR on the 5.875 percent is 5.892 percent. My father says I should take the expensive program with the lower APR but I'm really not that keen on increasing my loan balance by $13,000 to gain .625 percent in my rate. Should I suck it up and pay $13,000 to get the program with the lower APR?

Answer: No. Your instincts are good -- $13,000 is a lot of dough to pay in nonrefundable fees. I can't stand the APR and I take exception to the so-called "experts" who advise clients to go with the loan program that has the lowest APR (no offense to your Dad). Let me explain and crunch some numbers.

The biggest problem with the APR is that it assumes that the borrower will hold the loan until the end of the term -- an unrealistic assumption. If you hold the loan for 30 years, you will save a total of $16,920 by taking the lower rate, high cost loan because the payment difference is $47 per month. What we have is a $313,000 loan at 5.25 percent or a $300,000 at 5.875 percent. Since both loans are paid off in 360 months, the 5.25 percent loan that starts at $313,000 would be a better choice if the loan is held for the entire term.

But let's look a little closer . . .

The APR that is issued to you at the time of application is an estimate. Unless the lender is giving you a guaranteed closing cost package, such as a zero cost refinance, your true APR will be different from the initial disclosure because the closing costs are only an estimate.

The APR is also calculated incorrectly. It is supposed to give the borrower the true cost of the loan expressed as an interest rate when both the note rate and the transactional closing costs are taken into consideration. The problem is that the APR doesn't take into consideration certain fees. It considers bank-related charges such as points, appraisal and credit report fees, but it doesn't consider charges such as title agent or attorney settlement fees.

The APR also incorrectly includes interim interest in its calculation. Interim interest is just that -- interest on the loan. It mistakenly considers interim interest a transactional cost. Depending upon the settlement date, this can greatly vary the APR.

Let's get to the real numbers using your scenario. For the reasons listed above, we know that the APR on the 5.25 percent loan is inaccurate. The APR on the zero cost refinance is also inaccurate at 5.892 percent because the APR thinks interim interest is a transactional cost. The APR on a true zero cost loan will be the same as the note rate because there are no fees.

Here are the numbers:

The principal and interest (P&I) payment on a $313,000 loan at 5.25 percent is $1,728 per month for the next thirty years. The APR is 5.624 percent.

The P&I payment on a $300,000 loan at 5.875 percent is $1,775 per month for the next thirty years. The APR is 5.892 percent.

The loan program with the lower APR is $47 less per month, but $13,000 more expensive in nonrefundable fees.

Is your father giving you sound advice when he tells you to take the loan with the lowest APR? Let's compare.

As I said, if you were to hold the loan for thirty years, he'd be right, but that's not a reasonable assumption. I certainly don't know anyone in the last thirty years who has not at some point sold their house or refinanced. For most folks, it's unrealistic.

A more reasonable period might be seven years. At the end of seven years, the $313,000 balance would drop to $276,649 using a note rate of 5.25 percent. With a beginning balance of $300,000 and a rate of 5.875 percent, the balance at the end of seven years is $268,313, an additional $8,336 in equity.

But the $47 in monthly savings only totals $3,948 over seven years.

Let's try a 10-year holding period. The ending balance is $256,498 at the 5.25 percent rate and $250,214 at the 5.875 percent rate -- a difference of $6,284. $47 per month over 10 years adds up to $5,640 -- $644 less than the equity built with the higher rate, zero cost option.

The numbers don't lie. It takes more than ten years before you recoup the cost of taking a low interest rate, high cost loan. And I haven't considered the fact that more interest is paid at the higher rate, giving the homeowner an additional tax break.

The bottom line is you must be 100% sure that you will hold a loan for well over 10 or 15 years for you to benefit by taking a lower rate, higher cost loan. If you think you may sell before then, or you think interest rates might drop in the next ten years providing a refinance opportunity, it's best to take the higher rate and forego paying all those fees.