A Misleading APR on ARMs?

By: Jeff Brown

If you’ve boned up before shopping for a mortgage, you’ve probably been told to focus on annual percentage rate, or APR, rather than the basic rate.

That’s good advice if you’re shopping for a fixed-rate loan, but APR can be misleading when you look at adjustable-rate mortgages. In fact, you could see something quite baffling: an APR that’s actually lower than the stated rate. It looks like a mistake, but isn’t.

Federal regulations require lenders to report APR to better reflect the actual cost of a loan when various fees are taken into account. The higher the fees, the higher the APR.

The rules require that the cost of the fees be spread over the life of the loan, typically 15 or 30 years. Common sense tells you that adding these costs to the interest payments over that period ought to make the APR higher than the basic interest rate, which does not include the fees. It does work that way with a fixed-rate loan because the interest charge never changes.

But the calculations are trickier with an adjustable-rate loan, because the interest rate does change over time. Typically, the initial rate last for one, three or five years, and even seven or 10 years in some cases. After the initial period, the rate adjusts by adding a set number of percentage points, or “margin,” to an underlying “index.”

Typical indexes are the yield on U.S. Treasury bills with one year to maturity, or one of the London interbank offer rates, or LIBOR, interest rates banks charge each other.

In calculating the APR for an adjustable mortgage, the lender cannot predict how changes in the index will affect the loan rate after the initial period. So the rules require that the lender use the rate that would be produced if the loan were to reset at the time it is offered, and to assume that rate would stay constant for all the years after the initial period.

Currently, the average one-year ARM begins with a 4.642 percent rate, according to the BankingMyWay.com survey. The one-year Treasury is at an exceptionally low 0.46 percent. Using a typical margin of 2.75 percentage points, an ARM based on the one-year Treasury would adjust to 3.21 percent, well below the average starting rate of 4.642 percent.

So the APR calculation would assume the loan will charge 4.642 percent for one year, and 3.21 percent for 29 years. Even with fees included, the APR is likely to be lower than the starting rate.

In fact, there are many examples of this. J.P.Morgan Chase (Stock Quote: JPM), for example, offers a five-year ARM at a 4.625 percent rate with a 4.148 percent APR. Wells Fargo (Stock Quote: WFC) has one with a 4.375 percent rate and a 3.722 percent APR.

In the calculations, the rate used after the initial period is called the “fully-indexed rate,” or FIR. In the real world, this figure is next to meaningless because the rate will jump around from year to year, not stay constant.

Also, most borrowers do not keep their mortgages for the full 15 or 30-year term. The average mortgage is paid off in 10 years or so when the homeowner sells or refinances.

Since the fees included in APR are paid up front they can dramatically boost the real-life APR if you sell your home in just a few years. Imagine, for example, that you took out a $100,000 loan at 5 percent and paid $3,000 in fees. If you sold in 12 months, you’d have paid $8,000 in interest and fees, for an APR of 8 percent. Stretch the fees over 30 years, and they come to only $100 a year, giving you an APR of 5.1 percent.

Use the shopping tool to track down good ARM deals, but be sure to look beyond rate and APR to consider the underlying index and margin. Paying high fees is a bad idea if you won’t have the property very long. But if you’re going to stay for the long term, higher fees are worth paying if they allow you to get a lower rate in future adjustments.

To assess ARM offers, use the APR Calculator for Adjustable Rate Mortgages and the Adjustable Rate Mortgage Calculator.

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