- The Washington Times - Wednesday, January 10, 2007

The slight drop in long-term mortgage rates over the last few weeks has raised my hopes that rates will continue to ease throughout 2007. If this happens, the savvy-minded American homeowners are sure to line up for refinancing deals that will lower their interest rate.

I want to warn folks who are considering shopping for interest rates by comparing the Annual Percentage Rate (APR). I’ve written about this subject many times before, as the subject warrants plenty of attention. The bottom line is simple. The assumptions that go into calculating the APR are wrong in almost every instance.

The APR is supposed to give the consumer an idea of the true cost of the mortgage, expressed as an interest rate, after closing costs, points and other transactional fees are considered.

For example, my often-touted “zero-cost” refinancing might carry an interest rate of 6.25 percent for a 30-year fixed rate. With zero-cost refinancing, there are no fees or points charged to the borrower. Instead, the rate is slightly higher. Since there are no costs associated with obtaining the loan, the APR on a zero-cost refinancing loan is equal to the note rate — 6.25 percent.

Let’s look at a “bought down” rate of 5.50 percent. As of this writing, one might be charged 2 points, plus the typical transaction fees. Since 1 point is equal to 1 percent of the loan amount, the points alone would total $6,000 on a typical $300,000 loan balance.

Other closing costs, such as appraisal fees, title insurance, recording fees, and attorney settlement charges might total an additional $3,400, making the total nonrefundable costs for a 5.50 percent rate $9,400.

Which is better — the 6.25 percent rate with no fees or the 5.50 percent rate with $9,400 in sunken costs? Most would agree that the answer depends upon how long you hold the loan, which is exactly correct.

I pulled up my mortgage software and calculated the APR on both loans. As expected, the APR came out at 6.25 percent on the no-cost deal. The APR on the 5.50 percent loan came out at 5.703 percent.

Does this mean you should take the low-rate, high-cost deal? Sure, as long as you are certain you will hold the loan for the entire 30-year term.

This is where the APR should be thrown out the window. The APR makes the terrible assumption that the borrower will hold the loan until it is paid off in 30 years. It just doesn’t happen very often. People either sell their home or, more likely, take advantage of a drop in rates and refinance sometime within 30 years. Early payoff points and fees jack up the APR.

My mortgage software let me use the same fees and the same rate of 5.50 percent, but change the term from 30 years to 10 years. The APR bounced up to 5.990 percent.

When I changed the term to five years, which is much closer to the average time a loan is held, the APR shot up to almost 6.50 percent.

The bottom line: Paying fees and points to the bank in order to obtain a lower interest rate is akin to a layaway plan. If you still have the same loan in about 10 years, then perhaps you will have recouped the upfront fees in the form of a lower payment. But if, for whatever reason, you pay the loan off any earlier than the recoup point, you’ve lost money. Stick with a refinancing loan that carries little or no costs.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).



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