Quoted APR Vs. Actual APR
The annual percentage rate or APR is a very common acronym used to gauge pricing for a mortgage however its one of the most flawed methods because of the fallacy's involved when trying to use a standardized method to gauge an "unstandard," financial vehicle such as real estate:
- does not include the time value of money or better said the opportunity cost of the money if it were used or invested else where
- assumes a 30 year loan life with no refinances and loan is paid off by the 30th year while many properties are held for a much shorter period of time
- assumes no extra principal payments
- doesn't factor in other costs to maintain or to acquire property only that of the initial transaction (tax cost of funds, opportunity costs, other transaction fee's, early penalty withdrawals, and others are ignored)
Example:
400,000 loan amount 30 year fixed loan with 1.5 points at 4.5% and 4500 closing costs ----> stated APR is 4.73% on the truth in lending statement, however if the property is sold in a shorter time period the "real APR," may actually be higher
Held for 30 years - 4.73%
Held for 20 years - 4.74%
Held for 10 years - 4.86%
Held for 5 years - 5.12%
Held for 4 years - 5.25%
Held for 3 years - 5.47%
Held for 2 years - 5.92%
Held for 1 years - 7.25%
As you get farther away from the date of acquisition or purchase the costs get substantially lower closer to the fixed rate of 4.5%. The costs of the transaction have more time to evenly divide these upfront costs over the additional years hence reducing the perceived APR or cost to a consumer shopping for rates. This is also a good reason why it may not make sense for those who habitually refinance with fee's/points each time unless the benefit of the overall rate and costs are lower than the current costs of the loan being refinanced.
For some loans depending on the terms and if there are pre-payment penalties(PPP) or not it may be better to stick with the higher rate you may have especially if the PPP's cost far exceeds the expected benefit and the time frame in which you plan to keep your property.
Comments (2)
HI Shaun, I hear ya! Sometimes the incremental cost exceeds the incremental value of a particular decision. I try to help all my investor clients and every day borrowers with this. Instead of using emotions to make decisions I bring different perspectives to consider. Recently I had a client who wanted the maximum cash out of 80% instead of 75% but that additional 5% of cash out for instance may be $15,000 while the incremental cost of obtaining that $15,000 is 1.5 points or about $4,500 dollars. So by obtaining the additional $15,000 the borrower in this case only nets $10,500. The borrower would then have to earn over 42% return on this 10,500 in that year just to get back to break even with the 15,000 additional loan amount that they've added to their mortgage. So I would say if you cant out earn or have a use for this 10,500 dollars that far exceeds the opportunity cost of 42% it may not be such a great decision to obtain these funds. The greater use sometimes is not always financial as it may mean a life decision that is not quantifiable in dollars or cents but rather life style, family, or other sentiment.
Albert Bui, over 10 years ago
Great points. I doubt most people think about this going in. If you think you might refinance you need to look at if those points and fees buy you enough savings over your expected timeline to be worth it. BTW for me any prepayment penalty is like the only deal killer for me. Distasteful to me to get dinged for giving back principal.
Shaun Reilly, over 10 years ago