Governments have a way of doing things to the lowest common denominator. Unfortunately, the mortgage industry bears the brunt of a lot of legislation that when looked at objectively, makes zero sense to logical people. One of my favorites is the Truth in Lending (TIL) disclosure that mortgage lenders must provide consumers when applying for a mortgage.
The TIL is a disclosure that lenders use to calculate what is known as the annual percentage rate (APR). The APR is an interest rate that is recalculated after all of the costs associated with obtaining the loan are included. The theory behind providing an APR is that the federal government believes that consumers aren’t savvy enough to figure out that on a $300,000 loan a rate of 6% with no costs (loan A) is actually better than a rate of 5.875% with $5000 (loan B) in costs because most consumers focus too much on the interest rate and not the total cost of the loan. The APR calculation attempts to rectify this situation by providing the real rate with all of the costs. In our example, the APR on loan A is just 6% because there are no costs to be included. The APR on loan B is 6.02%. Therefore, when you consider the costs, loan A is the better deal despite having a higher interest rate because the fees are substantially lower. This is why federal law requires that mortgage lenders also provide an APR in advertising. When you see an ad for an interest rate, you will also see next to the rate quote an APR.
While the APR can be an effective tool to evaluate mortgage packages, there are some serious flaws that make it practically worthless in the real world. The flaws are as follows:
Time Horizon: The first flaw is that the calculation is done over the life of the loan which is typically 30 years. The average home owners lives in their home seven years. By shortening the time horizon for the loan, you significantly reduce the benefit of paying a large amount of fees for a slightly lower interest rate.
Consistency of Costs: There isn’t a consistent set of fees that are included in the APR calculation. This causes obvious problems. Some lenders include title fees, some lenders don’t. Some lenders include credit report and appraisal fees, some lenders don’t, etc As a result, unless you can compare exact fees across lenders, there really is no way to know if you are getting an accurate number.
Can’t predict the future: The biggest flaw with APR is that it only works on fixed rate mortgages. The calculation is even more useless if you want an adjustable rate mortgage (ARM). The reason is simple. No one knows what your rate will be in the future when you get an ARM making the calculation subject to worthless assumptions pulled from thin air. For example, if you get a 5/1 ARM. Your rate after five years is determined by an index and a margin. Unless you have a crystal ball, there is no way to know what the applicable index will be in five years. In their wisdom, the government says lenders are supposed to use the current index and margin as the rate assumption going out after the five year period is up. Need I really explain more as to why you can’t use TODAY’s rate as the rate assumption five years from now? Good God man, what are these people thinking?
Let’s demonstrate what happens when you consider the flaws. Loan A has a rate of 6% and $1000 in fees. Loan B has a 5.75% and $4000 in fees. Assuming a 30 year amortization, the APR on loan A is 6.031% and the APR on loan B is 5.875%. Seems like Loan B is the way to go. But wait, most people don’t live in their home 30 years. Let’s assume you are only going to live in the home five years as with most first time home buyers. Loan A’s APR is now only 6.138% while Loan B is now 6.301%. Clearly, Loan A is the best loan unless you are going to live in the property for a substantial amout of time. Of course, this only shows the first problem of time, but the other issues of consistency of fees and ARMs should be self evident.
Nevertheless, I will say that APR is a good starting point when evaluating mortgage loans, but it should be taken with a grain of salt. As always, if you have any questions about APRs or mortgages in general, don’t hesitate to give me a call.
What items or fee’s should be include in a TIL? Is their a book or internet site that shows how the APR is calculated? I would like to be able to calculate my own APR based on the fee’s the lender shows me on their GFE. How did you calculate the APR in the example above from 30 years to 5 years?
Stewart:
You bring up one of the flaws of the APR calculation that I warned about above. There is no standard as to what lender fees should be included, so it is very difficult for consumers to rely solely on the APR calculation in comparing mortgages.
I will direct you to wikepedia http://en.wikipedia.org/wiki/Annual_percentage_rate#Not_a_comparable_standard
which outlines some of the typical cost and whether they are included.
APR calculators can be found doing a quick google search and many of them allow you to adjust the years to be included. The actual formula for an APR calculation is complicated so you will need a calculator.
Last August I refinanced my Countywide HELOC with Wells Fargo. This is a “SmartFit Home equity account” with revolving credit in the amount of 50K. My loan was approved based on an appraisal which was never done. (The information came from county records.) Any Truth in Lending violation here?
Kris:
Lenders are not required to appraise a property. Many lenders use what is known as automated valuation models (AVM) which pulls data from public records to make a value determination. These systems are typically used with HELOCs and on some refinances with very low loan to values.
i have a second mortgage line of credit that is secured by the house which i was never given a TIL. do i have any recourse.