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If you’re in the market for a mortgage, you’re probably used to seeing two rates – a mortgage interest rate (or note rate) and an APR or annual percentage rate.

On most loans, the APR is higher than the note rate but adjustable rate mortgages (ARMs) can sometimes show an APR that is actually lower than the note rate.  Why is that?  Bob Walters, Chief Economist and Divisional Vice President of Quicken Loans, gives us the answer:

Why would the APR on an ARM be lower than the actual note rate?!  Isn’t the APR ALWAYS higher than the note rate?

Au contraire.

What is APR?  Annual Percentage Rate.  It’s a mathematical way to try and compare apples to apples.

How would you compare a 30 year fixed at 4.0% with 2 points to a 30 year fixed at 4.5% with no points?  APR.  APR takes the points into account and converts them into rate by using a mathematical concept called Internal Rate of Return (IRR).

And – APR does a pretty good job comparing IF the following are true:

1. The terms are the same (30 year to 30 year, or 15 year to 15 year or ARM to ARM)
2. The client holds the loan to maturity and never pays it off (or down) early
3. The loan is a fixed where future changes in rate are unknown.

See a problem with that?  Lots of holes in that piece of cheese.

So – how is APR calculated for an ARM?

Well – you know how many points you pay and you know how much the interest rate is for the fixed period – BUT – what about AFTER the fixed period?  What rate should you use then – after the rate starts to adjust?

Since nobody knows what the rate will be 5 years from now (in the case of a 5 year ARM) – APR ASSUMES that the rate will adjust to the rate it would adjust to today using today’s index and margin.  And then it assumes that rate will be in place for the remaining 25 years!

So – since the indices are so low right now APR assumes that the rate on the ARM will go DOWN after 5 years and it will stay at that low rate for the next 25.  So, when APR does it’s calculation on a 3.75% 5 year ARM – it assumes the rate will be 3.75% for 5 years (which is true) and then it assumes the rate will drop to something like 3.0% (whatever today’s index plus margin would get you) and stay at 3.0% for 25 years.  The math then averages that all together and the APR ends up lower than the note rate.

THAT is how the APR can be lower than the note rate.

If you have any questions about ARMs, APR or anything else in the mortgage world, send them to us at content@quickenloans.com.

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