Why the Lowest APR Isn't Necessarily the Best Loan
A hasty choice could lead you to the wrong mortgage
When getting a mortgage, it's wise to shop around for the best deal. But how exactly do you compare lenders? Many borrowers may compare the annual percentage rate (APR) from several lenders and choose the lowest one. That strategy makes sense in theory, but if you aren't careful, it can lead you down the wrong path.
APR is a valid comparison tool when comparing apples to apples, but lenders won't always make it easy to tell which loan is an apple and which is an orange. To ensure that comparing APR rates is the best strategy for you, watch out for some of these common pitfalls.
Are Fees Included?
Lenders have some wiggle room when they calculate APR for you. They may or may not include selected costs, but you still need to pay those costs. For example, appraisal fees, property taxes, and insurance costs may not be part of a given APR quote. Since different providers can charge different fees, comparing the APR becomes difficult.
More honest lenders include more fees, but that makes their APR appear higher. Make sure you understand all the fees involved in closing costs and how they relate to the APR.
The Federal Trade Commission has a comparison worksheet you can use to compare loans. The items under "fees" and "other costs" can help you know which extra fees to look for.
Low APRs May Come With Higher Upfront Costs
After you've figured out which costs are included in your APR, you should compare the upfront costs of a low-APR loan to a loan with a higher APR. Many borrowers will find that a low APR comes with higher upfront fees. That means you’ll have to quickly come up with thousands of dollars.
You might benefit from lower monthly payments over time, but is it worth it and can you afford those extra costs today?
Bait and Switch With APR
APR can also be deceiving as you review advertisements. Ads for lenders could boast attractive APRs—much lower than any you’ve come across. The catch is, while the lender might actually offer those mortgage rates, you might not qualify for them.
Those attractive APR quotes are for the best borrowers out there. If you have less-than-perfect credit, a small down payment, or you need a low documentation loan, you’ll have a higher APR than the best rate advertised.
Also, an advertised APR might not include mortgage insurance costs. If you need private mortgage insurance (PMI), your APR will be higher.
APR Assumes a Long-Term Relationship
APR calculations assume that a loan will be paid off over its entire lifetime. For example, the APR on a 30-year loan assumes that you’ll keep the loan for the full 30 years. In reality, many people do not keep their loans for the entire term.
If you pay off a 30-year loan after seven years, for example, a lower APR may not be as helpful as you’d like. You'll probably pay more upfront costs to get a low APR, and seven years of a lower APR might not offset the high closing costs.
If you pay your loan off early, the actual APR you’ll pay is higher than what you see quoted. APR is most accurate if you plan to keep a loan for its entire term.
The Bottom Line
While APR is a better comparison tool than a simple interest rate, getting the lowest APR doesn’t mean you’re getting the best deal. To figure out the best deal, you need to look at the big picture with all the cost items included, and calculate the effective annual rate, which represents the total interest rate charged..
Looking at the break-even point can give you some context. So can considering other uses for high upfront costs. For instance, instead of putting a few thousand dollars toward closing costs, consider how that money could be used in a retirement account.
By looking at the big picture and running some numbers on alternative scenarios you have a better chance of securing the best loan for your financial position.