Q: Why is the quoted interest rate on a mortgage different from the annual percentage rate?
A: 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. This 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 adjustable rate mortgages, lenders must take future interest-rate adjustments into consideration.
There's one problem. Nobody knows what those future adjustments will be.
Because we cannot know future interest rates today, the government tells lenders how they must calculate future interest expense using current rates. During the fixed period of the ARM -- for instance, 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.
That figure is often lower than the initial interest rate on an ARM, thus the lower APRs on adjustable-rate mortgages.
But the APR for adjustable-rate mortgages is based on an 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.
And the lower current interest rates are relative to historical rates, as they have been lately, the less likely they are to stay that low for the life of the loan.
Q: So, does the annual percentage rate on an ARM have any meaning?
A: Because APRs on adjustable-rate mortgages are based on the shaky assumption that interest rates remain the same, some experts tell borrowers to ignore APRs. But APRs are useful if you know what they can and cannot do. They cannot tell you what the loan will really cost you. But because they are all based on the same assumptions about future interest rates, 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.