The Government mandated way of looking at interest rates, the Annual Percentage Rate, APR, is not a useful tool for consumers. 

Purveyors of credit have historically tried to confuse people about the real interest rate they were charging. Not too long ago, someone would buy a $300 TV and the sales person would say, "Do you want to finance it?" We only charge 10% interest." That rate sounds reasonable so they would say, "Yes," and the salesman would to the following calculation. 

Does that sound reasonable? It isn't. The Annual Percentage Rate on this transaction is actually almost 18%, not 10%. The interest rate calculation, 3 x $30, assumes that the entire principal is repaid at the end of the 3rd year. Because you're making monthly payments, the average loan balance is only $150, not $300. At a real rate of 10%, the total interest due would only be $48, not $90. 

Now the actual payment at 10% is only $9.68, a difference of only $1.15 per month. Not much? Assuming the store did that on every TV, it would really add up. 18% on a few million dollars of consumer loans makes the lending business more fun than selling TV sets! What's worse is that "extra profit" was gained by misleading the customers, cheating them, if you prefer. 

To correct such abuses, Congress passed some laws to assure "Truth-in-Lending." Among other things they require lenders to give people disclosures telling what the Annual Percentage Rate (APR) is on the proposed loan. This has done much to correct such abuses but it has done almost nothing to correct similar abuses in the mortgage industry. 

In my opinion, getting a mortgage is a much more complex process than financing TV sets. There is a huge difference between a 3 year consumer finance loan and a 30 year mortgage yet our Government, in its infinite wisdom, chose to take the same law and have it apply to mortgage financing too. In addition, you get three pages of Disclosures on your loan too. The problem is that almost no one, seriously, almost no one, understands APR very well. Even if you have been well trained so that you know what APR really is, it doesn't help to analyze differences in APR to make a loan decision. 

That's because the APR model is seriously flawed. As you saw in the example above, the difference between 10% and 18% was only $1.15 per month. If someone told you that the APR on his loan was 18% and someone else said his was 10%, it would be easy - 10% is a lot less than 18%. But it's never, ever that simple. 

In calculating the APR on mortgages, the lender must calculate certain costs attributed to the loan. These are known as Prepaid Finance Charges. Without going into detail about what those charges are, APR is then calculated based upon your paying interest on the Total Amount Financed which is the loan amount less those Prepaid Finance Charges. Obviously the APR is always going to be higher than the Note Rate. But the differences in the same loan between lenders is only a few hundredths of 1%. 

A fundamental flaw is that the APR calculation is based upon the assumption that you keep your loan for the entire period off the loan, say 30 years. I'm sure that out of every 1,000 loans, there are 2 or 3 or 4 loans that are kept for 30 years but 95% of them are paid back far sooner. A more realistic way would be to "amortize" those Prepaid Finance Charges over the average life of the loans, not their full term. Thus the effect of this method of calculation is to exaggerate the effect of Discount Points. 

More to the point, you are only interested in what I will call Your APR. That number is based upon the amount of time you will own your house, not 30 years. A more accurate and useful method to come up with "your APR" is to amortize the points over the period you'll actually own the home. Let me demonstrate this in an albeit simplistic way. Let's assume you had a 10% loan with exactly 1% in prepaid expenses. Here's what the effective interest rate is, amortizing the points over the time you have the loan. 

Here's another way of expressing the problem that gets to the heart of the issue in the way people shop for a loan. 

Let's assume that a homebuyer asks me what the APR is on a loan he is interested in. Let's assume that I ask him what he had been quoted at other lenders and he says, "10.185%." I quickly calculate that I can get an APR of 10.185% if I have a 10% loan with zero points. I also know that all of my lenders also offer another rate vs. fee combination, 9.75% and 1 point, which it thinks is identical. Here's how those loans look side by side. 

The entire mortgage market, however, thinks that those two loans are identical, just two different ways of looking at the same loan. In their calculations, each loan has the same net yield. 

So he didn't necessarily get a better loan. In fact, by believing his government, he failed to analyze the situation in the most meaningful way. That's why no one in the lending industry (that I know of) looks at or cares about APR when they make decisions. I don't think that consumers should either. 

When it comes to adjustable rate mortgages, it's even more complicated. In calculating the APR on an ARM, the formula does all the calculations for the teaser rate period but assumes that once it gets to index + margin, say in year 2 or 3, it stays there for the life of the loan. Ladies and Gentlemen, that is a patently absurd assumption. Over the years the actual rate of every ARM is going to vary all over the place and is clearly not going to stay at today's rate. Whatever differences there are between one index and another, and we know from study that sometimes one is better and sometimes another is, the Government way makes it look, today, that Loan A is better than Loan B. 

That's dumb. Again, comparing APR is not the way to do your shopping. 

Now I'm sure that someone at HUD would say, "Well, what other number do you want us to use?" and the answer is that there is no way of knowing today, how the interest rates are going to vary over the next 30 years so there isn't a best number. What is flawed is not the inability to choose a number, it's the method itself. 

What people should have is a comparison of one ARM's historical performance compared with the performance of ARM's tied to other indices for the same period. That would show graphically that a loan tied to a lagging index is better when rates have risen recently, as it is today in 1996. Leading index loans, like those tied to T-Bills, are best during periods of declining rates, like 1983 to 1993. 

To wrap up, let's remember that your lender is required by law to send you RESPA forms within 3 days of your application. I would look them over carefully and ask questions about stuff you do not understand. But I wouldn't pay a lot of attention to the APR.