- - Thursday, September 6, 2012

Q. We purchased our first home two years ago and are thinking about refinancing. We didn’t pay a lot of attention to the mortgage process, something we regret today.

I’m trying to learn about various mortgage products on my own, and I’m confused about the annual percentage rate. Most Internet sites describe the APR as an antiquated tool that should be ignored. Other sites say it is the best gauge to find the lowest rate. Can you clarify?

A. I have enjoyed writing this column every week since 1996 and have written about the APR several times. I guess another piece on the subject is due.

The concept of the APR is admirable, but using it as a gauge to determine the best rate is foolish. I read a piece in the business section of the New York Times a couple of weeks ago about the possibility of a redesign of certain mortgage disclosures. The article correctly defined the APR but went on to say “some economists agree that the APR can be a misleading measure of a loan’s cost.”

Folks, I’m here to tell you right now that the APR is certainly a misleading measure of a loan’s cost, and I’ll explain why. Understanding the concept is important, however.

The APR expresses the cost of a loan as an interest rate when the loan’s note rate and all the fees associated with the loan are considered. For example, if a borrower takes out a 30-year fixed-rate loan at 3.25 percent, you might prematurely conclude he received a pretty good rate. Without knowing the costs associated with obtaining the loan, however, the 3.25 percent is meaningless.

If the borrower paid zero fees to obtain the 3.25 percent loan, the corresponding APR also would be 3.25 percent, and it would, indeed, be a very good rate. However, to receive a 3.25 percent 30-year fixed-rate loan in today’s market, the borrower would have to pay all transactional costs plus at least two discount points. On a $300,000 loan, that would add up to almost $10,000 in nonrefundable fees.

Clearly, the borrower’s true rate isn’t 3.25 percent if he has to fork out $10,000 to get it. In fact, my mortgage software tells me the APR is 3.431 percent.

Let’s compare this APR to my recommended “zero cost” option in which the note rate is higher but there are no fees. Because there are no fees, the note rate, currently quoted at 3.625 percent, and the APR are the same.

So why on earth do I insist the APR is a misleading gauge? Surely one would take the lower-rate, higher-cost option because the APR is lower, right? Wrong.

The problem with the APR is that it makes a bad assumption. To truly receive the APR of 3.431 percent, the borrower must hold the loan for the full term, which unarguably is a bad assumption. The fact is, folks just don’t hold loans for 30 years. The national average is closer to seven years. When I put a seven-year term into my mortgage software, the APR shoots up to more than 4 percent.

Unless you can predict the future with 100 percent accuracy, an APR is meaningless unless it is the same as the note rate, which would result in a zero-fee loan.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.