Why is the APR Lower Than the Mortgage Rate?

February 9, 2010 No Comments »

question

If you’ve been shopping mortgage rates lately, you may be wondering why the APR is sometimes lower than the advertised interest rate.

The APR, or annual percentage rate, is the interest rate of the loan factoring in specified closing costs like the loan origination fee, processing fees, mortgage insurance, and so forth.

That said, if a mortgage rate is fixed for 30 years, those fees will push the APR above the interest rate.

For example, on a $300,000 loan, a 30-year fixed mortgage offered at 5.00 percent with $5,000 in costs and fees has an APR of 5.15 percent.

But what about interest rates tied to adjustable-rate mortgages? Why do they always seem to display an APR lower than the rate? Don’t they have the same fees that would also increase the APR?

The answer comes in how ARMs are calculated; because they’re only fixed for a certain period, be it one year or five.

The remaining portion of the 30-year amortization period must be estimated, based on the current mortgage index plus the margin, which varies by bank or lender.

So if a a five-year ARM has a start rate of 4.00 percent, and the margin is 2.25 percent and the associated index is 1.00 percent, the mortgage payment would eventually adjust lower (for simplicity sake, to 3.25%) after the initial fixed five-year period.

In other words, during the first 60 months, the interest rate would be 4.00 percent, and the projected rate thereafter would be 3.25 percent for the remaining 300 months.

The result would be a lower APR, factoring in the perceived rate decrease, despite the fact that the associated mortgage index could increase during the fixed period.

(photo: mandigaga)

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