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Is There Any Truth in Lending?

C Spaker
Christopher Spaker, AMP
President, CNB Mortgage Company
[email protected]
(585) 385-2370 x50955

Applying for a mortgage is confusing enough, but when you apply, the lender has three days to mail you a Good Faith Estimate along with a Federal Truth in Lending disclosure statement, or as I affectionately like to call it, the Federal Truth in Confusion disclosure statement. The note rate (the advertised interest rate) is shown, along with the APR (annual percentage rate.) But what exactly is an APR? An APR by definition is an expression of the effective interest rate that will be paid on the loan. It is different from the note rate because it includes one-time fees in an attempt to calculate the total cost of borrowing money.

The APR is always higher than the note rate you are quoted. Why? Well, it’s partly because the APR is a somewhat artificial number. It is not the note rate on the loan and does not determine your monthly payment. It is calculated according to a formula determined by the federal government and was designed as a means for comparing one mortgage offer against another, even when the interest rates, points, and closing costs are different. The APR is supposed to help you determine your true cost of borrowing money. By looking at each lender’s APR, you should be able to determine which offer is most beneficial to you without having to look at the interest rates, points and closing costs for each one. The problem with this ideal is that no one lender calculates their APR exactly the same as the next, or so it seems.

What follows is a simplification of how the APR is calculated. The lender totals up certain closing costs associated with the loan along with the interest rate that was quoted to you. Those specific costs are then subtracted from your total loan amount which results in a figure lower than your total loan amount. The payment for your loan is then calculated as if it were the payment on that lower loan amount. As a result, the APR is higher than the note rate which you are quoted. Of course there are exceptions. An example of this is when the lender pays for all of your closing costs, commonly referred to as a "no cost" loan. Although there are no costs to you, there really are costs. The lender is just paying them for you.

The above explanation is a simplification of a very complex calculation. The calculations are poorly understood even by most financial professionals. Most lenders depend on software to calculate APR and are therefore dependent on the assumptions in that particular software package. While differences between software packages may not result in large variations, there are several acceptable methods of calculating APR, each of which returns slightly different results.

Some fees are deliberately not included in the calculation. Because these fees are not included, some consumer advocates claim that the APR does not represent the total cost of borrowing. An example of an excluded fee is the attorney’s fee. Lenders argue that the attorney’s fee is a pass-through cost, not a cost of lending. In essence, they are arguing that the attorney’s fee is a separate transaction and not a cost of lending.

Despite repeated attempts by regulators to establish consistent standards, APR does not represent the total cost of borrowing nor does it really create a comparable standard. Nevertheless, it is still considered a reasonable starting point for an informal comparison of lenders.

The biggest problem with the APR calculation is the assumption that a borrower will keep that particular mortgage until it’s completely paid off resulting in the up-front costs being amortized over the full term. But how many people keep a 30 year mortgage until it is paid off? Not many, because the odds someone will either refinance or move before the loan is paid off are very high. Computing the APR over the full term deflates the apparent cost of the loan, making it harder to decide if it truly makes sense to refinance an existing mortgage. In a perfect world, an APR calculator should allow the user to enter a loan retention period to better gauge the cost of the up-front fixed closing costs.