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Why Is the APR Lower Than the Mortgage Rate?

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If you’ve been shopping mortgage rates lately, you may be wondering why the APR is sometimes lower than the advertised interest rate. It’s typically the opposite as a result of closing costs, so it’s certainly strange at first glance.

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.

So 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% with $5,000 in costs and fees has an APR of 5.15%.

Because you’re actually only borrowing $295,000 from the bank if you have to give them $5,000 to get the loan.

Why Does This Happen?

  • The APR can be lower than the interest rate on an ARM
  • Because of the way lenders calculate ARMs
  • Since they’re only fixed for an initial period
  • They can use low mortgage indexes to their advantage to forecast a lower rate once it adjusts

But what about interest rates tied to adjustable-rate mortgages? Why do they always seem to display an APR lower than the mortgage interest rate? Don’t they have the same lender 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 the first five of their usual 30-year term, lenders have to consider the big picture.

Put simply, they have to assume you’ll hold the mortgage to maturity, even if you sell the home or refinance the loan long before then.

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

For example, if a five-year ARM has a start rate of 4%, and the margin is 2.25% and the associated index is 1.00%, 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%, and the projected rate thereafter would be 3.25% for the remaining 300 months.

The result would be a lower APR over the life of the loan, factoring in the expected interest rate decrease, despite the fact that the associated mortgage index could in fact increase during the fixed period.

Higher Rates and Indexes Will Change the Math

  • As mortgage rates and indexes increase
  • We will see the opposite occur
  • A higher projected interest rate at the first reset
  • It could make the APR higher than the current rate

While low APRs may be a common occurrence while interest rates are low, quite the opposite can happen once rates (and mortgage indexes) begin to creep higher.

Using our same logic from above, but taking a fully-indexed rate that is higher after those first five years, you can see why the APR would actually be higher than the rate, which is more the norm on all types of home loans.

So don’t expect it to always look this way, and if you’re unsure, ask why the APR is what it is. Or simply look at your loan paperwork to see what rate they’re projecting. You should know it anyway to ensure you can afford it!

In summary, mortgage lenders can use the math in their favor to make the home loan look more attractive than it appears.

Ultimately, this is yet another illustration of the limits of the APR calculation, which is inherently flawed due to the uncertainty of how long a borrower will actually retain the mortgage.

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