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 I suggest we talk about the so-called “no-cost” refinancing. First of all, this commonly used name for a refinancing option one can find very useful under certain circumstances is in fact rather misleading, because:

• No-cost does not mean free from any costs;
• No-cost refinancing helps you only with the Non-Recurring Closing Costs;
• No-cost refinancing still leaves you to pay at least Property Taxes, Interest, and Insurance.

Now that you’ve been warned, let’s take a closer look and find out about the circumstances under which this option can be useful.

Any refinancing involves a number of fees charged by both the lender and third parties. The fees are rather numerous and can add up to quite a considerable amount. You can either pay it all yourself or opt for the “no-cost” alternative. In the latter case, the lender will pay most of the refinancing fees at the moment of the refinancing itself, but it is going to cost you a higher interest rate on your new loan. The interest rate on a loan resulting from no-cost refinancing is usually 0.250% – 0.500% higher than that on an equivalent borrower-paid-closing-fees loan. This is the lender’s way to return the money he actually lent (not gave!) you by paying the refinancing costs: he just bought you some negative points. The rate will be high enough for the lender to be able to recover the complete amount. The new loan may include prepayment penalties, as the lender wants to make sure, the money does get to be repaid. A true no-cost refinancing employs only the interest rate to return the money. Unlike a “no-cash” mortgage closing option, there should be no increase in the total amount borrowed on that account. It is very important to make sure that both you and the lender have a clear and agreed upon idea of how the refinancing fees are going to be repaid.

Even though you are the one to pay all the costs after all, I dare remind you, the lender’s one-time helping hand contribution at the refinancing will not cover all the settlement fees. Very likely, it will only take care of the non-recurring closing costs, such as the appraisal fee, the credit report, the lenders’ fees, the broker fees, the title insurance, the escrow fees and the recording fees. The non-recurring refinancing costs, such as the property and transfer taxes, the interest (the new loan’s interest from the day of closing to the first day of the following month and the interest on your old mortgage from the first of the month to the closing day), and homeowners insurance are still totally your responsibility.

The most important thing is to be aware that even no-cost refinancing calls for quite some of your cash anyway and results in a higher interest rate loan. Considering all this, I still believe that this type of refinancing can be much of assistance to borrowers who are willing to get rid of their current loan for some reason, but are short of cash to pay all the refinancing fees themselves. It’s true that they will need to invest some of their own funds into the process, but the amount will be considerably lower than the complete settlement costs.

The resulting high interest rate is a bit of a pain, though, as the monthly payments are higher, but it takes a while (the breakeven period) before it really starts eating your money. It is easy to estimate roughly how long this while will be in your particular case: look at the difference in your monthly payment for a no-cost loan vs. a loan with costs and then divide that difference into the amount of non-recurring closing costs that you would have to pay at closing.  The result of this calculation is the number of months, during which the no-cost refinance loan is a sensible deal. If you have to keep this mortgage longer, it turns into a rather costly deal.

For that matter, no-cost refinancing is generally useful to people, who are not planning to stay in this particular mortgaged property for a period of time longer than the above mentioned break-even period.

Finally, if your fortune changes and instead of being short of cash you suddenly happen to have plenty of it, you can try to refinance again and attain more reasonable conditions. Mind the new refinancing costs and the possible prepayment penalties, though.

Points are quite a useful tool helping a borrower to lower the interest rate on his mortgage loan. The price of one point equals to 1% of the amount you borrow. If you pay this 1% amount in cash at the loan origination, the interest rate of your loan will drop by usually 0.25 percentage points. Each new discount point bought lowers the loan interest rate by another 0.25 percentage points. Thus, a 7% original rate can be reduced to 6.5% by buying 2 points. Sometimes the 0.25 percentage points off the rate become pricier if you go for more than 2 discount points. The lender may require that you buy, say, 3.5 discount points to reduce a 7% rate to 6.25%.

You cannot buy your interest rate totally out, though. Usually lenders offer several combinations of the rate and points for you to choose from.  If you see a 7% and 2 points offer in an ad, it is not very likely to be the only option available. All you have to do is ask.

Even though the idea of discount points looks rather attractive, I find it important to draw your attention to a number of subtle matters involved, and help you avoid any financial losses that may occur if the points get to be applied inappropriately.

As I have mentioned before, points have to be paid for in cash. If you are low on cash at the time of the loan origination, do not buy points, first make sure you have enough cash for an at least 20% down payment. Avoiding PMI is a lot more important!

The calculator can help you estimate whether points can be any use for you at all. Even though they do reduce the rate, the price of this reduction is pretty high. The points are not cheap and you have to make sure they are worth the money. The key to this estimation is the break-even period – a period of time by the end of which the amount you have paid for the points and as monthly payments becomes equal to the amount you would have paid as monthly payments if you had not bought any points. This is the break-even point. Only after this moment the points will start to really save you some money. The length of the break-even period usually varies around 3-4 years, which brings us to the bottom line of the paragraph – buying points only makes sense if you are sure that you will keep this particular mortgage longer than that. Long-term Fixed Rate Mortgages potentially have the best return on points.

Points bought for a short term Fixed Rate Mortgage may yield some return, too, depending on how long you stick to it. Buying points for an Adjustable Rate Mortgage is usually a less wise choice. The rate you buy down will hold only during the initial period, i.e. until the first rate adjustment. The advantage that you do get, though, is that the lower initial rate determines a lower maximum rate, if the overall maximum rate cap of your Adjustable Rate Mortgage is a value relative to the initial rate, as opposed to an absolute one. And for that matter, there’s been a word around of lower point prices on short initial rate period Adjustable Rate Mortgages. The break-even rule holds for Adjustable Rate Mortgages, too, but it is harder to estimate, because of the changing indexes and rates.

The usually painful question of taxes proves to be quite significant and still painful in regard to points, the effect they have on the interest rate, and consequently, the amounts paid towards interest. Interest payments, as well as point payments, made in a given year are deductible in that year. On a purchase transaction, points are deductible in the year of purchase, but on a refinancing, points must be deducted over the life of the loan. There are other regulations about the deductibility of points that are explained on the IRS web-page. However, each case is unique and requires special attention, consideration and professional advice.

One general rule holds, though: the lower the interest rate > the smaller the amount of money paid as interest > the lower the amount you can deduct from taxes.

Now, the last, but not the least – negative points (also called “rebates”). This is the way points work the other way around: the lender pays some of the closing costs for you in exchange for a higher interest rate on your loan you have to accept. Negative points can become your (rather expensive though) way out of a situation, when you cannot afford paying all the mortgage closing costs yourself. It is, I’d say, quite a desperate and costly measure. I wouldn’t recommend resorting to it, unless it is really necessary. If you got yourself into a mortgage with negative points, try to get rid of it as soon as possible. Do not wait until the overcharged interest rate depletes your funds.

And always remember – you are not obliged to buy any points. They are just an option provided for your convenience if you want it that way. Nobody can make you buy any points if you don’t feel like doing so.