Why APR may not tell the whole story
The annual percentage rate of a loan basically tells you how much a loan really costs, including fees and fluctuations in interest rate.
For fixed-rate mortgages, the APR is fairly straightforward. The fees you paid to take out the loan are added to the interest expense, spread out over the number of years of the loan.
That increases the real cost of your loan, which is why the APR of a fixed-rate loan is higher than the actual interest rate.
For adjustable-rate mortgages or ARMs, however, another factor comes into play. In calculating the APR for these mortgages, lenders must take future interest rate adjustments into account.
There's one problem. Nobody knows what the future rates will be. So the government tells lenders how they must calculate future interest expenses using current rates.
During the fixed period of the ARM -- five years for a five-year ARM -- the interest is at the stated rate on the loan. For the remainder of the loan, or 25 years, the rate is assumed to be the current mortgage index the loan rate is based on, plus the margin (the percentage points added to the loan to form the interest rate).
That figure is often lower than the initial interest rate on an ARM, thus the lower APRs on these mortgages.
And the APR for ARMs is based on the assumption that index rates will be exactly the same every time the loan adjusts as they are the day the APR is calculated. That's about as likely to happen as the weather is to stay the same. It won't.
In addition, current interest rates are so low relative to historical rates, it's unlikely they will stay that way for the life of the loan.
That's why some experts tell borrowers to ignore APRs. But APRs are useful if you know what they can and can't do.
They can't tell you what the loan will really cost you. But they can help you compare similar loans.
Just don't shop for a loan based on APR alone. Take into consideration all factors, including the stated interest rate, fees, possible future rate changes and the length of time you intend to own the house before you make a final decision on which mortgage to buy.
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