APR vs APY: What The Difference Between Note Rate and APR Tells You

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I have in the past told people to ignore APR. APR should not be used to compare between loans. Not only is it a one dimensional number used to measure what is fundamentally a two-dimensional trade-off between rate and costs, but it is computed based upon you keeping the loan for the entire period - no refinancing, no selling the property, not even paying off the loan earlier. Basically, nobody does this. Why pay attention to a number that doesn't tell the entire picture, and wouldn't apply to you even if it did?

But there is something that the difference between the putative APR and note rate can tell you: How big the costs of the loan are. Don't read too much into this. As I may have mentioned a time or two, at loan sign up, these are only the rate and fees that they are admitting to. The APR is subject to every bit of low-balling that the Good Faith Estimate (or Mortgage Loan Disclosure Statement in California) is. Furthermore, be advised that prospective loan providers are permitted a lie, I mean an error, of a full eighth of a percent for fixed rate loans, twice that for ARMs. So be aware that unless you are careful to nail down prospective loan providers by asking all the right questions and requiring a quote guarantee, what you get won't be any more accurate than political spin.

Where this is primarily useful is in reading advertisements. Not that mortgage rate advertisements are a good place to be looking for loans, but people will persist no matter how much I warn them against it.

APR does not include all costs. Federal Reserve Regulation Z allows mortgage providers to exclude third party costs from the calculation. This includes escrow, title, and appraisal costs at a minimum, as well as notary and processing costs, if they are performed by outside providers. I'm going to assume a 6% thirty year fixed rate loan. For such a loan processed "in house" for $400 would have an APR of 6.056, while the same loan where the $600 processing was "contracted out" instead would have an APR of 6.044. Note that you pay $200 more for the loan with the lower APR! You therefore need to know what's included and excluded when comparing APRs. For the same reason, a loan where there's a difference of $1000 in fees due to one loan's title company, escrow company, or appraiser padding their pockets while those associated with the other loan don't, will not show up under APR calculations. If other factors are the same, the expensive loan will have precisely the same APR as the cheap one.

With all that said, let's look at a thirty year fixed rate loan, starting from a $300,000 balance, with $1500 of closing costs included per regulation Z, first, with all closing costs included, then paying all costs but no points (par), then with one point, then two points. These are rates that were really the best available when I wrote this, but seem very high now.

Zero Cost
1 point
2 points
Note Rate
Total Cost
Note Rate-APR

Note that a loan with two full points is pretty expensive. It costs almost $9400 in actual costs, never mind impounds or prepaid interest that you may also be adding to your balance and paying interest on. Nonetheless, it boosts APR over note rate by less than 1/4 of a percent, and that the actual APR keeps going down even though the costs are skyrocketing. This means that for people who shop by APR, loan providers will advertise a loan with even more points. Even though you'll never recover the costs of those points, if all you look at is APR, the lower rate looks better.

Now let's hold everything else constant, but pretend that you have a choice between refinancing a $300,000 balance on a 6% thirty year fixed rate loan with all costs paid, where you pay the costs but no points (par), with one point, and with two points. This is never going to actually happen - the cost differentials you will shop between will not be that broad. If there's that much difference between the loans you're being offered, something is wrong. It could any of a number of things - I can't tell exactly what without a lot more information. This much variance should never happen - I'm doing this solely for illustrative purposes, so you can see how costs influence APR. There is always that tradeoff between rate and costs, and they are more likely to discover physics that repeals gravity than economics that repeals this relationship.

With that said, here's the comparison.

Zero Cost
1 point
2 points
Note Rate
Total Cost
Note Rate-APR

Now keep in mind, that every number here in this article is as correct as I can make it. This is, once again, to illustrate how various factors influence APR, not to illustrate the games that can be played with APR.

What other factors influence APR?

The size of the loan makes a difference. A $100,000 loan with $1500 of included costs (per Reg Z) at a note rate of 6% has an APR of 6.142, while a $400,000 loan with the same costs has an APR of 6.035. Note that this is a pretty low-cost loan, but it makes a real difference to comparatively small loan amounts. The difference ordinary costs make for smaller loans is one reason why folks with smaller loan balances should focus far more on cost than rate. Given that most people don't keep their loans longer than about three years, it can be very difficult to recover increased initial costs of doing the loan via lowered interest costs.

The basic note rate also influences how much the same cost influences APR. A $300,000 loan with $1500 in non-excludable costs (under reg Z) at 9% has an APR of 9.056, a difference of (actually) 556 basis points higher, while the 6% loan with the same costs has an APR of 6.046, an actual difference of only 463 basis points. Lower note rate means that the same costs influence APR less.

The term of the loan makes a huge difference. If that same thirty year fixed rate loan at 6% in the previous paragraph was a 15 year loan, it would have an APR 6.078. Not only can this mean that at shorter loan terms, a lower cost loan with a higher note rate can actually have a higher APR, if further illustrates how counter-productive paying attention to APR is. When the APR is computed as if you allocated those costs over the term of the loan, and most people sell the property or refinance in three years or less, the proper term to compute spreading those costs over is two or three years, not thirty. If cutting that period in half, from 30 years to 15, almost doubles the APR spread, what do you think cutting the period still further does? I'll tell you: If you only keep that same loan three years, the effective APR is 6.333 - and this is a very inexpensive loan. That two point loan from the first example at 5.875 that gets you the low payment has an effective APR of 7.549 if you refinance it after three years! Not only that, but you're going to be paying for it in the form of higher interest costs on a higher balance for as long as you have a home loan, and probably quite a while thereafter. By comparison, let me call your attention to that true zero cost loan at 6.75% from the same example, which has an APR of 6.750, no matter what period it is computed over. If you're going to refinance or sell in three years, which of these loans do you think it makes more sense to choose?

Caveat Emptor

Original article here


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About this Entry

This page contains a single entry by Dan Melson published on October 2, 2019 7:00 AM.

How to Effectively Shop For A Listing Agent (Part II) was the previous entry in this blog.

Offers Where The Buyer Knows About A Problem With Your Property is the next entry in this blog.

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