How to understand the best options for mortgage refinancing
Question: I am trying to help my son and his wife look at different mortgage refinancing choices. I thought that I could find the effective rate of a loan (APR) by dividing the costs of the loan by the loan amount, then adding that to the quoted rate. For example, a 6.5 percent interest rate on a $150,000 loan with closing costs of $5,000 would be 6.83 percent. When I compare other loan APRs, this math doesn't always match up. What's up with this?
Answer: The APR, or “annual percentage rate,” is intended to help borrowers better understand the cost of possible loan choices and provide a way to quickly and easily compare mortgage options.
According to the Federal Trade Commission, the “APR takes into account not only the interest rate but also points, broker fees, and certain other credit charges that you may be required to pay, expressed as a yearly rate.”
Generally, to compute the APR, you first have to look at the interest rate, the 6.5 percent in your example. Then you add in related fees and divide by the potential length of the loan.
But, this calculation often doesn't work. Here are two reasons why.
First, notice what the FTC said in its APR definition. “Certain” fees are used to figure the APR –¬ but not all fees. The $5,000 number used in your example may include costs that are not part of an APR calculation.
Second, the APR is computed over the potential life of the mortgage, say 30 years. This sounds reasonable for purposes of comparing loans, but makes little sense in the real world because few mortgages are outstanding that long.
For instance, the financial impact of $5,000 in fees is far greater over 10 years than over 30 years.
As an alternative to the APR, ask lenders to quote the “par” rate for any mortgage offer – the interest cost with zero points. Then compare closing costs separately.
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