Question: I am currently shopping around for a mortgage to refinance my $300,000 mortgage. My objective is to get the lowest fixed rate available. I have seen a few quotes as low as five percent but a friend says that I need to compare the Annual Percentage Rate. So far, each lender I spoke with told me not to worry about the APR. Can you shed some light on how to get the best rate in the market?
Answer: Unfortunately, the Annual Percentage Rate (APR) isn't the best method to determine whether or not you're getting the best rate. The APR is designed to give the borrower the cost of the loan, expressed as an interest rate, after costs and future rate adjustments are considered.
For example, let's say you're quoted a note rate of seven percent with no points or closing costs. The APR will also be seven percent because there are no costs associated with the loan and it's not subject to change.
Now, let's say you are quoted a fixed note rate of 5.50 percent. This lender is charging you the standard closing costs such as appraisal fees, recording fees, underwriting fees, etc. These closing costs add up to $2,800. The lender is also charging a one percent origination fee of $3,000. On top of that, because the interest rate is "discounted" to 5.50 percent, the lender is charging four "discount points", totaling $12,000. So your total costs for the 5.50 percent rate is $17,800.
The APR takes these costs into consideration. Even though your note rate is 5.50 percent, your APR will be something closer to 6.75 percent.
Okay, does this mean you should take the 5.50 percent loan with $17,800 in fees because the APR is lower than seven percent? Definitely not. One of the biggest problems with the APR is that it assumes you will hold the loan for the entire term. Statistically, very few people actually hold a loan for 30 years.
The difference in monthly payment from seven percent to 5.50 percent on a $300,000 loan is $292. Basically you are paying $17,800 in up-front, non-refundable fees to reduce your mortgage payment by $292. Is it worth it?
If you divide $292 into the $17,800 you will see that it takes 61 months, or five years to recoup the costs. But since you need to take out $17,800 from your savings account, you need to consider the interest lost on the $17,800. Using a mere three percent return, you lose $45 per month. Subtract the $45 from the $292 and a more accurate difference is $247 per month. Your payback period now extends to 72 months, or six years. It's also important to consider the tax implications by paying a higher interest rate but that's a subject for a different day.
The bottom line here is that the APR isn't the best way to determine the "lowest" rate. The last thing you would want to do is pay thousands of dollars in fees for a low note rate if you think you may sell the property in a few years.
My advice is this: Get a few quotes from recommended mortgage brokers for loans with no fees whatsoever. This will ensure that you are truly comparing apples to apples when rate shopping. Once you have found a good lender with a competitive zero fee rate, the loan officer can review other rate options that carry fees and discount points to determine whether it makes sense to buy down your rate.
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