Something weird is happening. It's hard to explain, yet you know that appearances can fool you. That's right. The Annual Percentage Rate for ARM Hybrids are actually lower than its corresponding Note Rate. And you thought you were the only one to notice!

What am I talking about? What is all this nonsense? Due to the way APRs are calculated for adjustable rate mortgages, the APR is actually lower than what you'll pay each month using the interest rate shown on your note. But this is just temporary, as adjustable rates rise, we'll see APRs for ARMs go back up.

The Annual Percentage Rate, or APR, is correctly defined as "the cost of money borrowed expressed as an annual rate." The goal for the Feds was to try and help consumers compare like loans from different lenders. But because the ultimate agreement on how to calculate APR is elusive, the APR is disparaged by many in the industry today, scoffing at its importance. But it is indeed valuable when you have lenders who know how to correctly calculate this number.

The APR attempts to calculate a mythical interest rate that takes into consideration more than just the note rate itself, additional fees required by the lender to obtain the loan. If Great Big Bank and Really Small Bank both charge 7.00% for the same loan, it's hard to tell who has the better deal. But the APR could include additional lender fees required to close the loan such as Processing or Underwriting charges. If Great Big Bank charged $5,000 in origination fees plus $500 for underwriting on a $200,000 mortgage, the APR number would calculate to 7.28%. Yet if Really Small Bank charged nothing except a $300 processing fee, the APR would be closer to 7.02%.

The variance in APR numbers for the exact same loan program would clearly show that Great Big Bank, while offering the same rate, charges a lot more for their money. That's quite easy when comparing fixed rate mortgages. But what about adjustable rate mortgages?

ARMS are calculated, not with the "start" "teaser" or "initial" note rate, but with their "fully indexed" rate. The fully indexed rate is the loan's index plus margin. Let's say you're choosing a 5/1 Treasury ARM - a loan that's fixed for five years then magically turns into an annually adjusting mortgage - with a 2.75 index. Five years from now at your first adjustment, all things remaining the same, your lender will take the One Year Treasury Index of 2.64 and add the margin of 2.75 to arrive at 5.39%. Your new rate would then drop to 5.39% if indeed the One Year Treasury index were still at 2.64.

You'll be hard-pressed to find any 5/1 ARM today at 5.39%, hard pressed that is without additional discount points or origination fees. That's how APRs for ARMS are calculated, using the fully indexed rate, not your start rate. Why? When calculating APRs for fixed rates, it's a given throughout the life of the loan what the interest rate will be. It's fixed. But with an adjustable it's impossible to predict with any certainty where rates will be throughout the life of the loan. So for comparative purposes, lenders have chosen to use the current fully indexed rate when calculating APRs for adjustable rate mortgages. And today, those indices are relatively low when compared to most mortgage note rates. So there. Now you know.

Published: April 12, 2002

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, a veteran Mortgage Banker, successful Real Estate Consultant and author of Your Guide to VA Loans, Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan, Who Says You Can't Buy a Home!, and Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You, is a former columnist and Contributing Editor with San Diego-based Mortgage Originator Magazine. Reed is President of CD Reed Mortgage Bankers, Austin, TX and is a Past President of the Austin Mortgage Bankers Association.