The Annual Percentage Rate (APR) was created with good intentions to make complicated things if not simple, then at least simpler. It even works in many cases! Unfortunately, it also fails in just as many other cases, which sort of devaluates it as a universally reliable tool.

The APR looks a lot like an interest rate, because it is also a percentage. However, it is quite a different parameter. The APR is the sum of the interest rate and a theoretical percentage rate derived from other then the interest, fees associated with a mortgage: points, pre-paid interest, origination fees, attorney and notary fees, closing agent’s document preparation fees, PMI. Third party services, such as appraisals or credit reports, are not included. The purpose of this rate is to summarize all the costs of a mortgage into one number and help a potential borrower make a more informed choice. The borrower should be able to compare mortgages by comparing their APRs. Ideally, a mortgage with the APR of, say, 6.25% should be a better deal than a mortgage with a 7% APR, implying that the latter’s closing costs are higher. The APR is usually higher than the quoted interest rate, but it does not influence your real monthly payments. The monthly payments are dependent on the interest rate; the APR is a purely technical theoretical parameter developed to assist the choice of a potential borrower. It immediately gives one the overall idea of the costs involved. Even though in real life these costs are upfront and paid in a lump sum, the artificially created APR assumes, that the total amount of the origination fees & Co is rather spread over all the years of the loan’s life. A little bit of this money is allocated to each monthly payment, as if you were paying the origination fees bit by bit all through the years. It is only an assumption in order to produce a number called the APR in order to help you as a borrower to compare different mortgage offers. Federal law requires that the APR be disclosed alongside the actual interest rate. For example, if you are looking at two otherwise identical offers – one of 5% interest rate and 6.5% APR, the other of 5% interest rate and 7% APR – the conclusion is obvious: the former offer is better, because you get the same mortgage with lower closing costs. Unfortunately, this is about the only situation, when the APR gives us a fair and reliable comparison. If the interest rates are different, the APR can be quite misleading. For example, if we have two mortgage offers with identical APRs of, say, 8%, but different interest rates of 5% and 5.5%, the decision immediately becomes more complicated than these two numbers. Why is one rate lower? How many points does it cost? Is it worth for you personally paying the points? There are other issues as well.

To explain that I will first have to use an oversimplified and unrealistic example: assume you have a basic (no PMI, no escrow etc.)30-year fixed rate mortgage for $100,000 at 5%. The closing cost you $10,000. Each monthly payment consists of a certain amount towards the principal to repay $100,000 and an amount towards the interest. The APR calculation does not simply add the $10,000 closing costs to the balance; it rather treats it as a second no-interest loan with a term equal to the term of the main mortgage. The easiest way would be to take the $10,000 and distribute it evenly throughout all the 360 months of the 30 years, but it would be an absolute amount, no more descriptive or comparative than just knowing the closing costs. To create a relative parameter, the closing costs pay off amount allocated to each month is a percentage of the outstanding balance of the main mortgage; the balance shrinks with time as it gets paid off, so the amount derived from it as a percentage also changes. The APR is the percentage rate that provides enough flow to pay off $10,000 through 30 years plus the interest rate of the mortgage itself. As you can see, the calculation is not all that simple after all, that is why the use of specialized calculators is highly recommended when checking the APRs provided by lenders.

Why check?

The APR provided by a lender assumes that the borrower sticks to the mortgage for all the 30 years of its life. The closing costs are spread throughout all the 30 years, which means that the pay off amount allocated to each month is lower than if you keep the 30 year mortgage for 10 years only. The same amount spread over a shorter period of time gives us a higher monthly payment towards the upfront costs, i.e. a higher APR. The point here is: if you know that you will not keep the mortgage for all its term, do not rely on the lender’s APR. Use a calculator where you can enter the expected period to estimate the real APR of the mortgage offers you are considering. You can also fiddle with the down payment and points amounts to see which combination produces a better APR.

There are several other situations where an APR-based comparison fails to perform: cash-out refinancing vs. the cost of a second mortgage; a mortgage with negative points; a HELOC.
While comparing the costs of a cash-out refinancing with a second mortgage, a borrower is provided with the APRs of the second mortgage and the new mortgage s/he refinances into. That’s what s/he is offered to compare. However, the real life equation is more complicated: the losses caused by the usually higher interest rate of the refinanced into mortgage are not taken into account. For example, you have a 6% mortgage with the outstanding balance of $100,000 and 10 years to go. You need another $20,000, i.e. either a second mortgage of $20,000 or a new mortgage of $ 120,000. If the interest rate on the $120,000 mortgage is higher than 6%, a difference in the cost of each dollar from the $100,000 borrowed the old way and the new way will occur. The refinancing APR does not take this difference into account, thus failing to describe all the costs of the refinancing, thus making the APR comparison of these two solutions inaccurate and misleading.

There are no universally agreed rules as to how to calculate negative points into an APR. Every lender has it his own way, which makes the APR provided rather useless – it cannot be used for a reliable comparison of products.

A proper HELOC should not involve any costs non-rechargeable at closing. This way the APR is just equal to the interest rate. A borrower should rather be concerned about the initial teaser rate and the rate margins and caps, while selecting a HELOC product. The APR disclosure is required by law, but not the disclosure of caps or margins!

• Second Mortgage vs. Cash-out Refinancing
• HEL & HELOC

A second mortgage is another (secondary and subordinate to the existing first mortgage) loan that you take out using your home’s equity as collateral. It provides you with cash, but it deprives you of the owned by the time part of your home, partially or completely. You have to start buying out your home practically all over again, this time on different terms – the terms of the second mortgage. What’s in the terms?

The crucial distinction of a loan secured by home equity is that the cash acquired can be used for anything – a new car, college tuition, or a bagful of groceries. It is not limited to one purpose only, as most other loans.

A second mortgage can be practically of any type. Some are easier to shop for, some are harder to find, but it’s all in your hands, backed up with your credit score. The complication factor is that a second mortgage is literally second in the queue for refund in case you default on your mortgage payments. The lender of the second mortgage will not have a cent of his money back until the lender of the first mortgage gets all that’s his first. Sometimes it is all that there is and there is nothing, or way too little, left to pay back to the second lender. This unavoidable risk of a second mortgage usually makes it more expensive through a higher interest rate in the lender’s attempt to compensate for a potential financial loss.

The first lender may also take notice of your second mortgage activity and extend the period of your PMI payments on the first mortgage, if you had any.

A second mortgage imposes certain risks on the borrower, too. One of them is second mortgage subordination. It is very important to have a clear subordination statement included into the second mortgage contract. Failure to do so may (and very likely will) make it impossible for you to refinance your first mortgage as long as the second mortgage is not paid off. When you take out your second mortgage, the lender agrees to subordinate it to the existing first mortgage on the existing terms. Any change in this balance may not be welcome, so make sure the subordination clause leaves you free to refinance your first mortgage at will.

No third loan of any kind – sad, but true – having two mortgages disqualifies you heavily from getting a third loan, should a need for it arise.

If the only purpose of your second mortgage is to raise some cash, you may also consider cash-out refinancing or a HELOC as its alternatives. Cash-out refinancing may happen to be more sensible if rates have dropped and the new mortgage will bear a rate lower than the rate of your current first mortgage. Watch out for PMI, though!

A HELOC is an adjustable rate mortgage that acts as a line of credit. It is secured by your home equity, so the interest rate is usually a lot lower than that of a credit card, and the interest paid is usually tax deductible (consult a tax advisor for details!). You get assigned a certain amount as your credit limit and after that you can draw different sums at different times, keeping the overall amount drawn within this credit limit. Your monthly payment includes the interest and, when some of the credit is used, a monthly minimum payment on your outstanding balance. Apart from that you determine how much you pay back and when. Usually, you have a 10- to 20-year period when you can draw on the line, after which you have a fixed period to pay off the outstanding balance plus interest.

The credit limit of a HELOC is up to 100 percent of the value of your home (its value minus all debts against it). Some lenders will allow you to borrow up to 125 percent of the value of your home, but don’t consider this to be easy money! However attractive the conditions may look, don’t forget – it’s your home you are gambling about! Should you default on your payments, that same lender who talked you into a 125% HELOC will knock on your door to tell you that it is not your home anymore.

A HELOC is usually a second loan, but it can also be a first one, if it was the first one you started after you had built 100% equity in your home. If you use your HELOC to pay off your existing first mortgage, the HELOC itself becomes a first loan in its stead.

A HELOC may be convenient for a person or a family, who will need to make a number of various payments over a stretched out period of time: for example, for home remodeling and a new car, or tuition and medical bills etc. Most home equity loan programs, unlike conventional mortgages, allow borrowers to use the money for whatever they wish.

People looking for a lump sum solution based on their home equity might want to consider HEL as an alternative. You can cash out by mortgaging up to 85% of your home’s equity. A HEL is usually a fixed rate mortgage, so the interest rate is lower than that of a HELOC (but higher than a conventional 30-year!). In fact, many HELOCs allow the borrower to draw a portion of the available balance and “lock it” thus turning that chunk of money into a HEL. The payment structure of a HELoan is identical to an equivalent conventional mortgage, but unlike the latter one, the cash can be used for anything.

You can use our calculator to estimate the costs of a HELOC.

In conclusion, I want to draw your attention to another very important issue that you should always bear in mind while considering a second mortgage at all: a second mortgage may prevent you from moving to a different location. If you happen to need to move to a different city, you may find it very difficult to sell your current home if your overall debt against this property exceeds its current market value. The money you will be able to get by just selling it will not be enough to pay off all the mortgages. All you’ll be able to do is default, and that’s really bad, because it ruins your credit score and makes it impossible for you to get a new loan at the new location. So my advice is always – do not drain the equity of your home too easily, especially during the times when real estate prices are not rising.

 Why do people refinance? All for different reasons, of course, but the most common ones are:

• To obtain a lower interest rate,
• To build the equity of their property faster,
• To change the type of their loan,
• To take advantage of an improved credit rating,
• To get some cash out of the equity already built in the home.

How does it work?

Obtaining a lower interest rate is probably the most popular reason to refinance. One may have an adjustable rate mortgage with a rate gone too high, or a high-rate mortgage resulting from negative points, or an above-the-average rate caused by the poor credit score at the time of the loan origination, or it may have been a very sensible loan all the way until mortgage market interest rates dropped. Refinancing in such and such like situations can save you quite some money, but you have to be very thorough in estimating the benefit. The main question is whether the amount saved will be worth the amount paid. The procedure of refinancing is not cheap, so you have to make sure, that the money you pay for it will not only return to you, but also gain you some profit as savings on the interest, as compared with your current loan.

One of the decisive factors is the length of the remaining term of your current loan and the term of the probable new one. If the former is short, refinancing will make little sense as there will hardly be any loan that will pay off in a better way than the existing one. If the latter is too short, there will not be enough time for any real benefit to occur. Generally, there is little, if any sense, in fiddling with refinancing short term mortgages, unless the current mortgage is a total killer.

Refinancing to a shorter-termed mortgage can, however, help you build the equity of your property faster. The interest rate of a shorter-term mortgage will most likely be lower, so you will actually own more of your home every year and at a lower price. Which is good, if you can afford it, because even though the interest rate is lower, the monthly payments may well become higher, if the new term is shorter than the remaining years of the current loan: the amount of your remaining balance will have to be distributed throughout a shorter period of time. If higher monthly payments do not bother you, you may also consider regular extra principal payments to your existing mortgage as an alternative. Depending on your situation, you may be better off with just the extra payments, avoiding the trouble and the expense of refinancing altogether. Use this refinancing calculator and this extra payment calculator to compare the options. The lower interest rate of a new mortgage will cut down the amount you can deduct from taxes as interest payments; extra principal payments to the existing loan have an indirect effect on the tax deductible amount – as the balance of the loan goes down faster, the amount paid towards interest (a percentage of the remaining balance) decreases faster, too. This latter decrease, however, usually compensates for whatever tax deductions. These are my general considerations, though, meant to draw your attention to the issue. The calculators mentioned above give you a concrete idea of the tax consequences.

Some homeowners prefer to refinance their adjustable rate mortgage to a fixed rate mortgage when interest rates fall. A lot of people take out adjustable rate mortgages during periods of high interest rates because the rates of the early years of adjustable rate mortgages are lower. The rates adjusted later, however, can become pretty high, and if there happens to be an overall drop in mortgage interest rates, it may become advantageous to switch to a fixed rate mortgage. Catch the right moment to refinance and enjoy the stability and comfortable predictability of a fixed rate mortgage.

If you are refinancing to get a loan that recognizes your improved credit status, you may want to call a credit bureau to get a copy of your credit report and make sure everything is reported correctly, before visiting a lender.

If you have owned your home for quite some time, you may have accumulated a considerable amount of equity in the property, which allows you to refinance your existing mortgage to an amount actually higher than the remaining balance of your current mortgage. As the amount of the new loan is bigger than your debt on the current one, you will have enough funds to pay off the mortgage you have now and still more to use for, say, your children’s education, or home improvements, or to repay other debts. “Cash-out” refinancing normally allows you to re-mortgage up to 90% of your property value. If, for instance, the value of your home is $200,000 and the current balance of your mortgage is $100,000, you can refinance to an amount equal to 90% of $200,000, i.e. to $180,000 and use $100,000 to repay the old mortgage. The remaining $80,000 cash can be used for whatever purpose you will find for it, and it’d better be a good one for the price. Which is..? Well, first of all, after all the years of repaying your debt and building equity in your home, you are going to lose most of it and start all over. A lot of people find it hard, as owing the place you live in does give you this secure feeling of home, sweet home. It is a kind of hard to wake up in the morning and realize that today it actually is not as much yours as it was yesterday. Moreover, apart from all the regular refinancing fees, you may have to face such additional monthly payments as PMI premiums.  If over 80% of the home value gets to be mortgaged, it triggers the obligatory PMI. If over 90% of the property is mortgaged the conditions can be highly unfavourable, so do not rush into such offers, no matter how easy the broker makes them sound. Don’t let anyone talk you out of your home. Always compare different offers, gather and study all the relevant information thoroughly before you agree to sign. Remember, this money is not a gift; it is your big debt that you will have to be repaying from the day on.

If the purpose of your refinancing is mainly raising some cash, you may also consider taking out a second loan of some sort instead, or refinancing into a Piggyback loan to avoid PMI. However, when you compare these two-loan options with “one-to-one” cash-out refinancing, don’t forget to take the non-financial issue into account, too. Even if the maths of the deal makes the second or the piggyback loan more attractive, there are still a couple of non-numeral variables in the equation: having a second mortgage (even a piggyback version of it) makes it practically impossible for you to qualify for any other loan should a need for it arise; the lack of proper subordination arrangement for the second loan may make it impossible for you to refinance the first loan later.

A separate big issue is prepayment penalties on both the old mortgage and the new one. As refinancing means paying off your current mortgage before its original term is over, you may have to face a penalty for the early repayment. It is not always the case, though. You have to check your contract and every supplementary note that comes with it, and see if you are in for the penalty on the day you are planning to refinance. With most lenders the prepayment penalty applies only to the first several years of a mortgage and will probably cause no problem at a more advanced stage. Penalties on the new mortgage can be rather painful, especially if you are refinancing into a mortgage, whose other terms are not exactly very friendly either. Sometimes circumstances make people go for such loans, but everyone wants to get rid of them as soon as possible, so make sure that your new contract will not include anything that may hinder you from doing so at the time you are ready.