APR and discount points: what you're really comparing

The note rate is the number your monthly principal and interest is built from. APR is a second number that folds in some of the upfront finance charges so a cheap-looking rate with heavy fees does not win by default. You need both, and you need them on the same lock length.

The CFPB puts both figures on page 3 of the Loan Estimate. APR is an estimate for comparison. It assumes you keep the loan for its full term, which almost nobody does. That single assumption is why the lowest-APR offer is often the wrong offer for a household that will move or refinance inside seven years.

Note rate, APR, and the charges that sit between them

The note rate is the contractual rate on the promissory note. APR annualizes that rate plus selected prepaid finance charges, using the payment schedule and term in Regulation Z. Origination and discount points usually go into APR. Escrowed taxes and insurance usually do not, at least not the way borrowers expect. Title work you shop yourself can change cash to close more than it changes the APR ranking. Prepaid interest moves if the closing date slips. An ARM's APR does not fully describe what happens after the first reset.

Discount points are prepaid interest. One point is typically 1 percent of the loan. The rate reduction per point is not a law of nature; it is that day's price sheet. Lender credits are the mirror image. You take a higher rate and the lender applies cash toward closing costs. Credits help when cash is thin. You pay more interest for as long as you hold the loan. Compare them on the same lock and the same loan amount as any points offer.

APY is a savings-account number. Do not compare a mortgage APR to a savings APY. Discount points on a purchase may be deductible in the year you pay them. Refinance points are often amortized. That is a CPA question, not a rate-sheet question. The CFPB's own explainer is blunt: APR is a comparison tool, not a promise that you will pay that exact percentage if you sell in year six.

When a point pays for itself, and when it does not

On a $360,000 loan, one point is about $3,600. Suppose it drops the rate from 6.75 percent to 6.50 percent and saves about $55 a month. Break-even is $3,600 divided by $55, about 65 months. Sell or refinance in year four and you did not recover the cost. Stay ten years and the point can pay, if you are willing to spend the cash now instead of keeping it as a reserve. In a year when rates look likely to fall, paying for a permanently lower rate is less attractive, because you may refinance before the break-even arrives.

Ask every lender for par pricing first: zero points, zero credits, same lock, same day. Then decide whether to walk up or down the sheet. Mixing a 15-day lock with two points against a 45-day lock with none is how people conclude something that is not true. Use your hold period, not the 30-year term. Most owners refinance or move well before year 30. Model the payment on the mortgage calculator and the APR math on the APR calculator.

The ranking that lies is the lowest APR on a loan you will not keep, a points loan compared to a par loan that was never re-priced, a credit that makes APR look worse while cash to close looks better, and an online table that assumes strong credit and undisclosed points. Compare rate, points, credits, and cash to close together. Read page 2 of the estimate next to page 3. The walkthrough is in how to read a Loan Estimate. Current market levels are on the market page.

A same-day comparison that does not mix products

Ask every lender for the same loan on the same morning: loan amount, term, occupancy, lock length, and par pricing, meaning zero points and zero lender credit. Write down the note rate, the APR, Section A lender charges, and cash to close. Only after that sheet exists should you ask what one point costs and how many dollars a month it saves. If you compare a 15-day lock with two points against a 45-day lock at par, you will conclude something that is not true about either lender.

Discount points on a purchase may be deductible in the year you pay them. Points on a refinance are often spread over the life of the loan. That is a tax question for a CPA, not a reason to pick the lowest APR on a loan you will not keep.

APR assumes you keep the loan for the full term. Most owners sell or refinance well before year 30, which is why the lowest APR can be the wrong offer for a household that will move inside seven years. Use the break-even in months, not the APR ranking. On the $360,000 illustration, one point at about $3,600 that saves about $55 a month needs roughly 65 months. Leave in year four and the point did not pay. A lender credit does the opposite: cash to close falls, the note rate rises, and APR can look worse while your checking account looks better. Credits help when cash is thin and you will not hold the loan long enough to recover a large fee.

Taxes, insurance, and title you shop yourself can move cash to close more than they move the APR order. Read page 2 of the estimate next to page 3. The page-by-page method is in how to read a Loan Estimate. Model the payment on the mortgage calculator and the APR math on the APR calculator, then treat the Loan Estimate as the document that counts.

Sources: CFPB, APR versus interest rate, CFPB Loan Estimate. Educational only.