In the first installment of this series we looked at some of the things to look out for when shopping for your mortgage . In the second part we talked about hidden fees and pre-payment penalties.  In this installment I'll talk about some of the ways to compare mortgage offers and what you can do to protect yourself when shopping for a loan. Knowing what to look for, and what questions to ask, puts you in a position where you can make an informed decision.

APR - The APR, or Annual Percentage Rate, is a measure used to compare different loan options. The rate on the APR is always higher than the note rate, the actual rate you will pay for your loan. As part of the Truth in lending Act, the government requires that any time a rate is advertised, the APR also has to be shown. This is an attempt at transparency and the goal is to express the total cost of credit over the life of the loan, taking into account how much it costs you to take out the loan so you could tell which offer was better, a loan with a higher rate and lower fees, or mortgage with a lower rate but higher fees.

This concept is a step in the right direction, but it really doesn't work as well as it could, and the result for most people it to leave them Dazed and Confused. There are a couple of problems with it. First, there is no one precise formula for determining the APR. Some costs are included in the calculation, and others aren't, and there are some costs, such as application fees and mortgage insurance, that can be considered a cost under some circumstances, but not under others. And other costs, like pre-paid interest which can be manipulated to change your APR for the better. This means that the same loan, with the same closing costs, can show different APRs with different lenders.

Another problem with the APR is that it balances the cost over the entire loan period. For example, the closing costs on a 30 year loan would be averaged over the entire 30 year period, even though all the costs are paid up front. In the real world, very few people stay in a loan for the entire time. Let's say you were comparing loans between two lenders and the closing cost on one was two thousand dollars higher than the other. Because you are averaging the costs over a 30 year period, the APRs would be very similar. But if you only stayed with that loan for seven years (with moving and refinancing so common the average time in a mortgage is closer to 5 years), it would turn out to be much more expensive than the lower cost loan.

Also, if you are going to compare APRs you need to compare with the same loan product. Comparing a 30 year fixed rate to a 15 year fixed won't give you a true comparison, and comparing a fixed rate to an ARM will be of no use at all. Loan size matters too. The cost of fees on a large loan will have less of an impact than higher fees on a smaller loan.

The Good Faith Estimate: Many people focus on the loan's APR, but the best way to shop is to directly compare the costs of one loan against another. To do this we use a form called The Good Faith Estimate of Closing Costs. This needs to be sent out to you after you've applied for a loan, but you should ask for it before you have committed to a lender. This form will show you the interest rate and program you are considering, a breakdown of your payment, a list of all the closing costs and pre-paids associated with the loan and a tally sheet showing the amount you will need to bring to closing. A lot of information is listed on the Good Faith, but when comparing loan offers the numbers you need to compare are the companies bank fees. Title charges, escrows and pre-paid interest can be changed around to show a lower bottom line, but the bank fees are the items that they can control. 

The Good Faith is an estimate, but it should be very close to the final numbers. Comparing offers takes more time, but it gives you a truer picture of what each lender is proposing. If a lender will not put his offer in writing, that should be a red flag that something may be wrong. In order to know what to compare, you need to understand what closing costs are spent on, and what to expect.

This still brings up the question of how you compare two offers if one has a lower rate but higher fees. To do this takes one more step, you need to figure your payback period. To do this you need to know how much the difference will be in your payments, and how long you plan on staying in the home. For example, say you are borrowing $200,000 and you have one offer of 6.25% with $1,000 in bank charges and another offer at 6.00% with $3,000 in bank charges. The payment at 6.0% is $1,199 for principal and interest. The payment at 6.25% is $1,231 - a difference of $32 per month. Now you take that $2,000 difference in up-front costs and divide it by the $32 difference in payments. This comes out to 62, which is the number of months before the lower payment will payback the higher fees you paid at closing. In this case it will be over 5 years before you break even - longer than that if you factor in the effect of inflation on your mortgage payments. If you are planning on being in your home for a long time and you don't expect rates to drop at any time, this could make sense, but it shows that the lower rate isn't always the best deal.

This approach takes a little more work on your part, but it gives a better picture of what option is best for your needs. In the next part of the series I'll go over the one thing that may be the most important factor when shopping for a mortgage.

Pete Thompson is an Illinois mortgage banker who provides superior mortgage service and competitive mortgage rates in Chicago, the Chicago area and throughout Illinois. Click here for a Free copy of The Real World Home Buyer's Guide - How to Save Thousands when Buying a Home and Getting a mortgage. For information on the latest mortgage news and current Illinois mortgage rates, please visit http://www.illinoismortgageratesandnews.com