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Interest Rate vs APR in Adjustable Rate Mortgage (ARM)

Contributed by mm | May 8, 2004 11:30 PM PST

For quite some time, I was very confused that for ARM products with the same interest rate, APR can differ. Also, for some ARM products, APR can be lower than interest rate, while for other ARM products, APR can be higher than interest rate. Sean McCarthy gave out a succinct answer in his Mortgage Guru web site.

"For Adjustable Rate Mortgages, a fully-indexed APR is used that is based on a comparison that is made at each adjustment date of the 'then current' rate plus 2% versus the margin plus the index. As part of this calculation, the index is assumed to remain constant throughout the life of the loan. When the underlying indexes are low, it is possible for the fully-indexed APR to be lower than the starting rate on the loan. During the past year the APR was considerably lower than the note rate on most ARM products."

In other words, ARM products with the same interest rate can differ in how interest rate will be determined after the initial fixed rate period, and that difference determined the variance in APR. In addition, that variance will only bring economic impact if the loan is not paid off or refinanced after the initial fixed rate period.

The take-away should be: APR should become a variable in a comparison shopping process too. As most people seeking ARM products will refinance or move out of the underlying property within the initial fixed rate period, the initial fixed interest rate should be the first decision factor. But if everything else is equal (interest rate, closing cost, points, etc.), a wise shopper should compare APR as well.

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