To follow up on the comments from Matthew J. Blum and Don Carter who weighed in on my previous posting about APR...
If you have 2 companies giving you a T-I-L and showing a 30 year fix at 6.5% and one apr is 6.8 and the other is 7.2% You know which way is a better deal.
Actually, the one with a lower APR can easily be a worse product Matthew. There are numerous reasons why this is the case -but if you consider the other factors I noted in the posting, it should be obvious.
For example, if the 6.8% APR has a prepayment penalty and the 7.2% one does not, the former is automatically a worse product if the person refinances or sells in that time period. (There are hard and soft prepays but I do not want to get too technical here for the sake of this brief posting.)
If the 6.5% APR product discloses 1 day of interest and the 7.2% product discloses 30 days interest, that is not insignificant. A lot of loan officers will put the minimum on a GFE that they can get away with and then later on they add a bunch of stuff. A lot of them also do not check off all the correct APR affecting sections. That is night and day from what mortgage consultants such as myself (who prefer to present the worse case scenario up front so that we can surpass client expectations) will do.
APR is calculated based on financed amount not loan amount and that is a key factor to consider. For example, if you are financing a purchase or refinance of say $150,000 and the 6.5% APR is financing $145,300 (due to the product having $4,700 in closing costs) and the 7.2% product is financing $149,500 (due to having $500 in closing costs), again the 7.2% product can easily be a better scenario even if the payments themselves on the 7.2% product are $40 per month higher. The reason for this is the tax consequences aspect I mentioned briefly in the earlier posting.
In other words, just because you have two loans at 6.5% interest rate and one has an APR that is .4% higher, that does not necessarily make the higher APR product a worse one for the consumer.
While I agree with your general premise, I don't agree that it's entirely useless. The purpose of an APR calculation is to give borrowers a shopping tool, not to make a decision on long term financial planning, which seems to be what you're implying.
I realize what it is intended for Don but the presumptions behind its calculation make it useless and deceptive. As I noted in responding to Matthew, since APR is calculated in part (I say "in part" because there are three factors that go into calculating APR correctly) on financed amount, the more closing costs there are, the lower the financed amount and thus the lower the APR.
In other words, how does a potential borrower compare the cost of a 30 year fixed rate mortgage with zero points to one with 2 points?
The one with two points can be a better product for them actually. I would need to see more than just what you note to say for sure one way or the other mind you but it is not possible to tell the better loan based on what you just noted in that sentence.
The APR was designed to be a tool to help put those two scenarios on a level playing field and help the borrower compare relative costs.
I realize the intention but intentions alone do not cut it.
In addition, most closing costs are included in the APR calculation.
Well now, I would not say that actually. Jeff Belonger in the comments box explained why quite well so I quote him on it now:
A little reality check. It's up to the lender to check off what items are suppose to be included in the APR. There is a box. It it not regulated at that time, but only when files are looked at again after they have closed. It's regulated by state agencies and auditors. This is a huge problem because when shopping, it can be a free for all.[LINK]
I noted this earlier in the posting but Jeff mentioned the regulatory part of it and that is key: if he and I were competing for a loan and I checked off all the boxes I was supposed to and he did not{1}, there is no way to prevent him from doing this up front to artificially suppress his APR to look better than mine. There are sections we are required to check off to present the figure as accurately as we can but that is not caught up front. For that reason, it is not uncommon for someone cto be lured into shopping you for a lower APR and end up later on finding out the APR is either (i) higher than they were initially quoted when the final papers are in front of them or (ii) the same as quoted but a worse product come tax time for them.
I have not explained yet how APR is calculated but should I do that at some point, a much clearer picture would be painted. Nonetheless, I hope that the above material helps to illustrate a bit more about why the APR -even though by law we are supposed to disclose it- is a useless figure for proper loan comparison and frankly is open to no small degree of unethical manipulation.
Note:
{1} This is not to imply Jeff would do this of course but is for illustration purposes only.
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Shawn if you are going to quote me you can use my name first off. I stand behind whatever I say. I did say that your explination was good. However, if you have 2 exact loans than you should look to the apr. In this case it seems you where not looking at 2 exact loans. I do agree with Jeff (who by the way I sent him your post because I thought it was well written) that your explination was quite good and I agree how many times people don't know how click on the right box to figure out the APR. Next time if you have aproblem you can always e-mail me direct.