Truth In Lending and APR

The Truth-In-Lending is a form that can or does provide some useful information, but the useful information it provides is both smaller than most people think, and not in the numbers everybody looks at.



The first thing to be aware of is right below the title. "This is neither a contract nor a commitment to lend." They are telling you right there that this is an estimate. It may or may not be an accurate estimate, but most often it isn't, since it is based upon the Mortgage Loan Disclosure Statement, with all of the games that lenders play with those. It's no better than the MLDS form. Remember, Garbage In, Garbage Out. How accurate the MLDS is depends upon the loan officer and the provider they work for. Again, the relationship between this form at the beginning when you apply for the loan and the loan that is actually delivered with the final documents can be extremely tenuous.



The APR in the very first box is the result of an attempt by Congress to compress what is fundamentally at least a two-dimensional number into one linear measurement. It is intended to help give you a direct, one number measurement of the effective interest rate, given the expenses. But, in order to this it has to make some assumptions



The first of these is that you're never going to sell. Back in the early 1970s with stable secure jobs for a large portion of the populace not only in government but in private industry as well, and people living their whole lives in their first house, this was a reasonable assumption. No longer. The median time for ownership duration is about nine and a half years.



The second of those is that you're not going to refinance. This also was not an unreasonable assumption back in the early 1970's. Our habits as a society have changed since then. The fact is that the median age of mortgages (half older, half younger) is currently about two years. Only something like 4 percent of all mortgages are older than 5 years. I'll have other implications of these facts later, in other essays.



But by making this assumption, that you're never going to sell and never going to refinance (again, for the fifth time) and just make that minimum payment every month for thirty years, it allows the illusion that you're going to spread those costs out over thirty years, when the appropriate time frame is much shorter. This is a dangerous illusion. To give a specific example, because it means that, when measured by APR, a 5.5% loan with closing costs plus two points looks like a better loan than a 6 % loan with closing costs but no points. In fact, it is quite likely that the 6% loan is a better idea, and a 6.5% loan where the lender pays your all of your closing costs for you may be better yet.



Let's go through the calculation involved. Assume they're both thirty-year fixed rate loans, so you'll actually keep getting benefits as long as you keep the loan. Assume the base loan we're looking at is $450,000, the same figure I've used elsewhere. This can be either an existing loan, or a purchase where you need $450,000 beyond your down payment to cover purchase price and costs of buying.



As we computed in looking at the Good Faith Estimate, the closing costs of doing this loan are somewhere in the neighborhood of $3400 or so. But "third party" costs, such as escrow and title, are excluded from APR calculation, so we're going to deduct about half of that, or $1700, from them when we calculate APR. I'm also going to assume that you actually pay all of your "prepaid" and "reserve" items out of pocket, which keeps things simple. Your actual loan amount in the case of the 5.5% loan with two points is $462,650, and your monthly payment is $2626.89. Your actual loan amount in the case of the 6% loan is $453,400, and your monthly payment $2718.36. The third loan has a payment of $2844.31 on a balance of $450,000 even. The APRs (a complex calculation) work out to 5.685, 6.035, and 6.500 percent, respectively. Quick Side point: Loan 1 has a difference between the stated rate of less than .2 percent, despite the fact it has two full points on it as well as normal closing costs. So when you see on where the difference is more than that, it measn they're adding even more in points and fees, and that's just what they tell you to get you to sign up. Returning to the main point, looks like the Loan 1 is a better bargain, right?



Your actual interest expense the first month is $2120.48 the first month for the first loan, $2267.00 for the second loan. This is a difference of $88.34, and this number is actually going to increase for the first several years of the loan. The rest of the money is a principal payment. Equity. Money you don't owe anymore. The principal paid the first month on the first loan is $506.41; on the second is $451.36, a difference of $55.05 the first month in the first loan's favor. For the third loan $2437.50 represents interest and only $406.81 is principal. This is really looking like you make the right choice with 5.5%, correct?



But let's look at two years from now - about the age of the median mortgage. I'm going to use the loan in the middle as baseline.

Loan # Interest paid Principal paid Remaining balance Diff in int pd Diff in bal Net $ to you

Loan 1 50,228.84 $12,816.17 $449,833.83 $-3532.83 $7912.78 $-4379.95

Loan 2 $53,761.67 $11,479.02 $441,920.98 - - -

Loan 3 $57,866.96 $10,396.38 $439,603.61 $4105.29 $-2317.37 $-1787.59

Loan 1 has paid less in interest, and more in principal than Loan 2. Looks great, right? But they also paid $9250 more for the loan, or which $7912.78 remains on their balance. Remember, fifty percent of the people have sold or refinanced at this point. When you sell or refinance, the benefits for the lower rate stop. But the cost is sunk. You paid it in full two years ago. And at this point if you sell this home, you will actually have $7912.78 less in your pocket than in if you had taken the 6% loan. This is somewhat compensated for by the fact that you spent $3532.83 less in interest expense. But you're still $4379.95 down as compared to the 6%, and there's no way around that. Meanwhile, the 6% loan has more than paid for itself (only had a quarter the cost of the 5.5% loan) as opposed to the 6.5% loan by this point in time.



And if you refinance, it gets even worse. You're now paying interest on the $7912.78 in higher balance for the rest of the time you're got your home. Let's say the rate is 5% now because you got an even better deal. This means $395.64 per year, $32.97 per month extra that you're going to pay for as long as you have that loan, all for benefits that you don't get anymore and never paid for their costs in the first place. This is truly the gift that keeps on giving, isn't it?



Now let's look 5 years out, when over 95% of the people will have sold or refinanced.

Loan # Interest paid Principal paid Remaining balance Diff in int pd Diff in bal Net $ to you

Loan 1 $122,731.53 $34,881.02 $427,768.98 $-8878.65 $5860.53 $3018.12

Loan 2 $131,610.18 $31,491.54 $421,908.45 - - -

Loan 3 $141,907.77 $28,750.60 $421,249.40 $10,297.59 $659.05 $-9638.54

At this point for loan 1, you have saved in interest and paid down more in principal, right? Yes, but you paid more for the first loan than you would have for the second, and you still owe $5860.53 of this difference. If you sell, you will get $5860.53 less to put in your pocket, although that will be more than balanced out by the interest you saved. Net profit to you of choosing the first loan: $3018.12, neglecting tax treatment. Boy did you make the right choice, right? But remember that over ninety five percent of everyone who made the same choice you did never made it to this point. Furthermore, if you're like most people and you intend to buy some other property where the transaction includes a loan, that loan will have a starting balance $5860.53 higher to start with than if you'd chosen loan number 2 in the first place. Assume you got a great rate on your new home: 5% even. This means, even if the money doesn't cost you anything in points, that you're now paying $293.03 per year in interest that you wouldn't be paying if you'd simply chosen Loan 2 in the first place. Assuming you intend to own property for the rest of your life, in a little over ten years your gain is gone.



On the other hand, you are doing safely doing better with loan 2 than 3 at this point. The difference in interest you've paid has more than made up for the difference in starting balance. Whether you refinance or sell, it's going to be difficult to make up $9638.54 with the interest based upon 659.05. Assuming 5%, this is $32.95 per year, which means it takes over 300 years to recover, and I don't know anyone seriously planning to live that long, even discounting the time value of money.



Now, if you get a great deal and refinance instead of selling, that extra $5860.53 that you still owe on that mortgage is still there, and will be for as long as you own that home. Assume you got a really great deal of 5%. This means $293.03 per year of extra interest expense - just from the fact that your balance is higher because of sunk costs to pay for benefits that have stopped. Assume you keep your home another five years, so altogether you've had it ten years since the initial loan. This has cut your gain to $1552.97.



This happens all the time. It is not uncommon for me to talk with people who bought their homes in the 1970s, have refinanced ten or twelve times, and now owe more than ten times their original purchase price, a good portion of which is directly attributable to unrecovered closing costs of the refinances. Here's the point: closing costs and points stick around, sometimes a long time after the benefits you got from them are gone, and people refinance or more often than most people admit. The only loan that CAN be ahead from day one is the true zero cost to the consumer. Everything else will pay for itself eventually, and more than pay for itself if you hang onto it long enough, but you're sinking a significant amount of money in the bet upfront, money which is going to be around in your balance a long time. Furthermore, people don't hang onto these loans as long as they think they will, and very few people hang onto them long enough to see profits from high closing cost loans. Finally, the rate at which a zero cost loan can be done varies from day to day, and by quite a lot over time. Let's say six months from now I can do a 6% loan no cost. It costs you zero, and now if you're loan 3, you've got the same loan at a lower balance than the guy who chose the 6% loan 2 above, whom I can't necessarily help right now.



Then three years down the line, rates really drop, and I can do 5.5% for no cost. A call to both loan 2 and loan 3 nets borrowers who are eager to cut their rate for zero cost, but I still may not have anything that helps 1 in the sense of being worth the cost of doing it. Now loan 1, loan 2, and loan 3 all have the same rate, but loan 3 owes the least amount of money, therefore has the lowest payment, and has the most equity in their home.



Here's another dirty little not very secret, but rarely publicly acknowledged, fact: People don't always refinance into a lower rate when they refinance. If you've been a homeowner 15 years or so, chances are reasonable that you've done it - possibly more than once. Don't worry, I'm not going to pillory you in public over it, but if you won't admit it to yourself then there's not a lot that can be done for you. People have various reasons for refinancing into higher rates, some of them reasonable, some of them relating to necessity, and some quite frivolous. But you'd be amazed at how often people looking to refinance expect me to believe stories that numbers show to be obvious fiction about how often they've refinanced a property. This is math, and if the numbers tell me you've been making payments on this loan for two years when you tell me five, I'll bet millions to milliamps that if I go check the public records that are maintained on every piece of real property in the country I'll find that Trust Deed recorded two years ago. Now, it's okay to tell some lies of certain kinds to your loan officer, and assuming that any prepayment penalty has expired, this is probably one of them. No harm, no foul. What a typical loan officer cares about is getting paid, and if you're withholding or correct information doesn't make a difference to that, there's been no harm done. A good loan officer will add, "Putting the client into a better position" to that first, paramount concern, and if the information you withheld would have resulted in a different answer to this question, you have only yourself to blame. (Looking for altruists in business is both pointless and hazardous to your financial health. Businesspersons donate huge amounts of time and money and energy to charities or other works for the public good. But we're at work to Make Money. I am very good at what I do and getting better because I want to Make More Money, and mistakes do the opposite of Make More Money). But you need to be completely honest with that wonderful person you see in the mirror every day who follows you around twenty-four hours every day, shares in all of your triumphs and joys, and has to deal with all of your mistakes for the rest of your life. Otherwise you're going to waste a lot of money on mortgages making the same mistakes over and over again.



Getting back to the actual Truth-In-Lending form, finance charge assumes you keep the loan the full term, as I have explained. Amount financed is subject to the same limitations as the Good Faith Estimate, and in fact assumes that the Good Faith Estimate is honest and accurate. So is the Finance charge. Neither of these, nor the Total of Payments, which is simply the sum of these two, is any more valid than the Good Faith Estimate this form is based upon. Do NOT use the Truth-In-Lending as a way to compare loans, numbers-wise. Many people do precisely this because it's such a simple looking, easy to understand form. But if it's based upon a Mortgage Loan Disclosure Statement that's not accurate, it means nothing. Zip. Nada. Garbage In, Garbage Out.



Nope, the minimal information provided by this form is in the details that start about halfway down.



Demand Feature: If checked, this means the lender can require that you repay the loan in full, with a certain number of days (usually 30) notice. It can also mean there's a balloon on the loan.



Variable Rate Feature: if checked, this means that at some point, if you keep the loan long enough, become a variable rate loan. I've seen loans that went as long as ten years before a variable rate kicked in, or it can be right away.



Credit Life and Credit Disability are two products that I would generally recommend against unless it's the only life or disability insurance you can get. Some states do not permit them to be a requirement of the loan - and in those cases where the lender would otherwise require one or both, you won't get the loan as a result. (On the other hand, without these state prohibitions, many lenders would require them much more often, costing consumers in the aggregate billions. Just like everything else in mortgages, it's a tradeoff with winners and losers no matter what you choose.) Both of these products typically pay any benefits directly to the lender, when you want them to come to you or your family. Buying your own life insurance or disability insurance is typically a much better idea.



Property and Flood Insurance The lender can and will require you to maintain proper insurance on the property as a condition of your loan. In California, they cannot require this be for the full amount of the loan, but they can and will require you to maintain coverage for the amount of full replacement costs - what it would take to rebuild your property as it is from the ground up. Many lenders delegate the responsibility for making sure this is done on their behalf to big administrative operations that cover the whole country, and they are ignorant of individual state law even for such major states as California. Be polite, but firm, when they tell you they are looking for coverage in the full amount of the loan. Flood insurance is a separate policy that can also be required if the property is on a flood map. The lender can either demand your loan in full immediately or purchase insurance on your behalf and force you to pay the bill if you fail to show them continuing proof of adequate coverage. FYI: by Federal Law, flood insurance coverage doesn't kick in for 30 days after you pay the premium.



SECURITY: The first box should be checked for purchases, the second for refinances. In rare cases I do see somebody taking out a loan on a home that is free and clear to get a better rate than they would on a new property they're buying, because they'll get a better rate that way. In this case, the second box should be checked.



Filing Fees are for filing the papers with the county recorder, and should be the same as listed on the MLDS



Late Charge basically discloses what your penalty for any late payments will be. It is expressed as a percentage of your normal monthly payment.



Prepayment penalty: Should tell you honestly whether there will be a prepayment penalty on the loan, but often doesn't. Says nothing about the duration of it. Forget the second line. All of the costs to get you the loan are sunk and nonrefundable from the time you sign the papers. All of the interest that you pay as it is due is gone forever. You'll never see it again. They earned it. They're not going to give it back. I've never heard of a loan where in the initial contract the borrower was promised a rebate of part of those costs if they paid off early. Banks did make a lot of offers to discount loans if you paid them off in the late seventies and early eighties, but these were offers made at a later time, long after loan papers were signed, by the banks because they were losing their shirts buying money at 14% or so when it was already loaned several years earlier to customers at 6%. It wasn't a part of the contract in the first place.



Assumption: This means that if you sell the property, the buyer can keep your loan in effect. The VA loan is the only one out there that is generally assumable by the buyer if you sell, but there are some other loans that are assumable as well. It's not usually a good idea to let a buyer assume the loan, but there may be no alternative. The reason: You can still be liable for these if you do allow them to be assumed.



Then there's a line where there are two final square boxes to check, where "* means an estimate" and "all dates and numerical disclosures except the late payment disclosures are estimates. Expect the second box to be checked. It's all based upon the Mortgage Loan Disclosure Statement, which is nothing but an estimate, and in most cases is intentionally a drastic underestimate. If they're stretching the truth on that form, the numbers on the Truth In Lending are going to be similarly distorted. And if it's not checked, that's "an inadvertent oversight" and unlikely to be prosecuted. Which is as it should be - unless there's a pattern of it, which is the case with all too many loan providers.



Caveat Emptor