Why You Should Ignore APR
One of the things you get with every mortgage loan quote is an APR, or Annual Percentage Rate. There is even its own special form, the federal Truth-In-Lending (TILA) form.
This was mandated by congress back in the early 1970s as a way to give consumers some way to compare between competing loans of equal rate, and it is governed by Federal Reserve Regulation Z.
The problems with APR are threefold. First off, it is computed from numbers on the Mortgage Loan Disclosure Statement, which are often intentionally and legally under-stated. "Mis-underestimated," to use President Bush's famous phrase in an entirely different context where it is not a good thing. If the numbers on the Good Faith Estimate are incorrect, the computations that result in the APR will be similarly incorrect.
Here is a routine example, from an unfortunate soul I encountered awhile ago. They told him they were going to do his $230,000 loan for 3/8ths of a point and $1895, which works out to about $3400 total, APR was listed as 6.136 on a 6% loan when he signed up. But when the final documents were ready, the interest rate was 1/4 percent higher, the points were 2.25 points, and the closing costs were actually over $4000. Total cost: $9400 added to his mortgage, and the APR on final documents was 6.568 on a 6.25% loan. It stands out in my memory because I had been competing for his business, and offered to do a back up loan because I was certain the first quote wasn't real. He didn't want to do the paperwork for a back-up loan, but he came back to me during his three day right of rescission. Unfortunately, rates had moved up and by that point I couldn't do anything he liked better, so he rewarded the company who misquoted his loan (to use technical parlance, lied) by getting them paid. Unfortunately, you can't go backwards in time with what you learn at the end of the process. You need to be right the first time.
The second reason to ignore APR is that it is an attempt to compress what is fundamentally at least a two-dimensional number into a one dimensional number. Remember back in school when you learned graphing on a "number line" and then a Cartesian Plane? Which of them contains more information? The Cartesian Plane, of course. APR is an attempt to force a Cartesian Plane onto number line. In order to do it, you need to make some assumptions, and you still lose a lot of information.
The third, most important reason to ignore APR is that the assumptions that Congress and the Federal Reserve mandate were reasonably based on the reality of the 1960s, which has now changed. Back then, people bought homes they were going to live in for the rest of their lives, and re-financing was much less common. People are now living in homes about nine years on the average, and refinancing about every two years. But the regulation still reads that the costs of doing the loan, which are included in the APR calculation, are assumed to be spread out over the entire term of the loan, even with ARMs and hybrid ARMs, which almost nobody keeps after the initial fixed period. With the term of most loans being 30 years (some 40 now), and the average person refinancing about every two years, this computation makes absolutely no sense as it exists today. The costs of the loan should be spread over the period that the person getting the loan is likely to keep it, not the entire theoretical term of the loan.
Let us look at the earlier example in this light. Let's assume that it's a five year ARM, and compute APR as if he's going to keep it the full five years of the fixed period, rather than the thirty years he theoretically could keep it. The APR would have been listed as 7.067% on the final documents.
Let us go a step further and assume that instead of keeping his loan 5 full years, like less than 5 percent of the population, he keeps it for something close to the national median of two years, and compute APR based upon that. His final documents would have listed an APR of 8.293 percent.
To offer a better strategy: At the time, I could have done the loan at zero total cost to him - literally nothing. Zero added to his mortgage, he pays for the appraisal but is reimbursed when the loan funds - at 6.75%, APR 6.750 no matter how you compute. Yes, the payment is $17.75 per month higher than what he ended up with. But he wouldn't have added $9400 to his mortgage balance. Let's compare these two loans five years out, when 95 percent of the population has sold or refinanced and is no longer reaping the benefits of that payment that's lower by $17.75 per month. If he has the zero total cost loan I could have put him into his balance is $215,914.00, and he has paid $89,506 in payments. The loan he ended up with, he's going to owe $223,449, and he's paid $88,441 in payments. Okay, he's save $17.75 per month, about $1065 total, in payments. But he owes $7535 more. If he sells the property and puts it all in a savings account, he would have been permanently ahead by $6470 if he initially choses the higher rate, higher payment, but lower cost loan. Not to mention that he would get $7535 extra all at once, as opposed to little dribbles of $17.75 per month that most people would never notice. If he buys another house, or if he keeps this home but refinances, he owes $7535 less with the zero cost loan. Let's say he gets a really great loan next time, with a thirty year fixed rate of 5%. That $17.75 per month he "saved" on his payment for five years is still going to cost him $376.75 per year, $31.40 per month for as long as he keeps the new loan. This is what comes from relying upon APR as a valid measurement of a loan.
This is not nitpicking. The so-called 2/28 and 2/38 are the most common subprime loans nationwide. They are subprime hybrid ARMS with an initial two year fixed period. People get into them because they don't have the money for a down payment. With a dozen agents in my office, I can't tell you when the last time I saw a first time buyer who had the money for a down payment. Considering that they're all straining to buy as much house as they possibly can get a loan for, this means they're in the subprime market. According to SANDICOR figures I saw a while back, something like 40% of all purchase money loans locally in the last year being negative amortization loans which have no truly fixed period and are practically impossible to keep longer than five years with the best will in the world. Another thirty percent plus, according to SANDICOR, were interest only, so my estimate is that subprime lenders have at least eighty percent of the purchase money market locally, and probably fifty percent or more of the refinance market. With the vast majority of these loans being of the short-term variety as illustrated above, APR is worthless as a measure of a loan.
P.S. Just as a parting shot, let us consider the above situation in the context of a fifteen year loan that, to be insanely generous to the $9400 closing cost loan, the gentleman will keep until he pays it off completely. APR for the $9400 closing cost loan: 6.779 percent. APR for the zero closing cost loan remains 6.750. That's not a typo, the loan with the higher rate has the lower APR. Payment for the $9400 in closing costs loan: $2052.67. Payment for the loan with higher rate but zero closing costs: $2035.29. That's not a typo, either. The higher rate loan has a payment that's $17.38 per month lower, because you didn't add $9400 to the loan balance that you've got to pay back.
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