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!

Today’s article explains the equity way to close the financial gap between the new and the old homes’ mortgages.

A lot of people count on the money they are going to get from selling their current home to make a proper down payment on their new home and start a new mortgage. Unfortunately, many properties get stubborn at the point and refuse to sell while their owners are gradually getting frustrated at somebody else snatching the perfect home right from in front of their nose.

The frustration can be avoided in several ways, including financial aid from friends and relatives, or retirement accounts. If those fail, a bridge loan can certainly be of help.

A bridge loan is usually provided by the lender of the new home’s mortgage, but its collateral is the old home. Most bridge loans are short term high rate interest-only mortgages. The term is usually as short as 6 months; so if you are not sure that your current home will sell so soon, make sure there is an option in the contract allowing you to extend this period. Any lender will give you a hundred reasons to justify the high rate, but as it is an interest-only (if it is in your particular case) mortgage, the monthly payments do not add up to outrageous totals just because your current home is very likely to get sold well before the amounts involved go out of control.

A secured bridge loan makes it obligatory for you to sign your new home’s mortgage with that same lender, so always look first what the lender has to offer in the field of mortgages you are ultimately targeting on, because that latter one is the deal you’ll have to stick to for years. The conditions have to be favorable.

Bridge mortgages can vary in structure. Some pay off the first mortgage of the old home at the bridge loan’s closing and this amount adds to the sum you borrow to close on your new home. This total becomes the amount of your bridge loan and you pay interest on it until your old home sells and you receive cash to pay the loan off partially or completely. Thus, as you close on your new home, you will have two mortgages: a new first mortgage and the bridge mortgage.

The other way is just to add the new debt to the old one. This way you have three loans to attend to when you close on your new home: your old loan, your new first loan and the bridge loan.

Unsecured bridge loans are as rare as the circumstances which can suggest them. If your credit score is impeccable and you know for sure, i.e. have a binding contract of sale, that your old home will be sold at a certain date, you may try and find a bank that will write an unsecured bridge loan. As the lender is certain of the date and the amount of sale, he may be more willing to avoid putting a lien on that property. First and probably only choice is a bank, which you are already a client of, but even with them you may have to be quite insistent. Banks do not like short-term unsecured deals.

If your old home is not on the market yet, the choice of means is considerably wider. You can put the equity accumulated in your old property to work for you. You can start a HELOC, or a regular equity loan secured by the equity you have in your old home. The closing costs of these solutions are considerably lower than those of, say, a cash-out refinancing, but the rates are higher. A HELOC or some other high rate equity loan will come out overall cheaper if the “bridging” period is short. The longer the “bridging” period is expected to be, the more sense it makes to cash out by refinancing and pay a lower rate for as long as it takes for the house to sell. You can even rent the property out for some time to compensate for your expenses.

It is rather risky, I’d say, because it is secured by your home equity. Should you default on your payments, you can lose your home. But the purpose of HELOC is not to deprive you of your property; it is to provide you with some funds when needed. If you make sure that you understand how this mortgage works and do not give in to over-glitter-smiled conditions being pushed on you, you should be OK. Just do not tap into the equity too much.

Other risks to bear in mind, especially if a HEL/HELOC is your second mortgage, are: disqualification from a third loan; serious financial complications if you happen to have to move before the mortgages are paid off.

For more details read Second Mortgage.

And remember – a lot of people use HEL/HELOCs and are happy with the benefits.