November 16, 2017

APR stands for “Annual Percentage Rate,” and was designed to be a comprehensive measure of the cost of credit that mortgage borrowers could use to compare the cost of loans offered by different lenders, or loans with different features. The APR adjusts the interest rate to take account of all loan fees paid up front by the borrower to the lender. (Note: It does NOT take account of fees paid to third parties, such as appraisers or title insurers). Mortgage shoppers confront the APR as soon as they search for interest rate quotes, because the law requires that any mortgage interest rate quote by a loan provider must also show the APR.

The APR was formulated originally by the Federal Reserve in implementing Truth in Lending legislation, which was given to the Fed to administer. When the newly created Consumer Financial Protection Bureau (CFPB) assumed responsibility for mandatory mortgage disclosures from the Fed and from HUD a few years ago, the APR was part of the transfer. While CFPB thoroughly revised many of the other disclosures they inherited from the Fed and HUD, the APR has not changed. The major weakness in it that I pointed out to the Fed 25 years ago has never been fixed.

Assessing Offers From Different Loan Providers: Because the APR is a measure of cost, it should be most relevant to the borrower’s decision to accept the offer of one loan provider while rejecting that of one or more other providers. Cost is relevant to other types of decisions, such as selection of the best combination of interest rate and upfront fees, but those decisions may be dominated by cash or payment constraints.

On November 10, a mortgage shopper with excellent credit, prepared to put 20% down, was offered two deals on a 30-year fixed rate mortgage. Lender A offered a rate of 3.25% and lender fees of $10,184 while lender B offered a rate of 3.625% with fees of $2,603. B’s rate was higher but the fee was lower. Which was the better deal?

Lender A’s loan had an APR of 3.51% while B’s had an APR of 3.69%, indicating that the borrower will do better with A’s loan. The problem is that this conclusion is as likely to be wrong as to be right. To understand why, it is necessary to look at how the APR is calculated.

The APR Calculation Procedure: The APR is what economists call an “internal rate of return”. The calculation combines interest paid every month with fees paid up front by assuming that the fees are spread over the entire loan term -- 360 months in my example -- in such a way that the sum of the rate payment and the allocated fee divided by the loan balance equals the APR in every month. But if the actual life of the loan is shorter than the assumed loan term, which is usually the case, the calculated APR will understate the true cost of the loan. The shorter the life of the loan, the larger the understatement of cost.

The assumption built into the APR that all loans run to term is wholly arbitrary. If the calculation procedure instead assumed that the loans will terminate in 7 years, which is about the average life of 30-year loans, the APR of A’s loan would rise to 3.81% and B’s loan to 3.77%. Where the official APR calculated over the term indicates that A’s loan is less costly, an APR calculated over 7 years indicates that B’s loan is less costly, though not by much. Going further, APRs calculated over 3 years would be 4.42% and 3.92%, turning the original conclusion on its head.

To avoid a possible misunderstanding, any APRs a reader is quoted or sees on-line or in ads is calculated on the assumption that the loan runs to term. The APRs calculated over 7 years and 3 years cited in the paragraph above are mine, using the same procedure but different assumptions about mortgage life. The purpose is to show that an APR can be calculated over any period.

The Obvious Remedy: In disclosures aimed at live applicants, the APR could be, and therefore should be calculated for the period specified by the applicant. In the case of generic rate quotations, APRs could be shown for term, half the term and 3 years. I petitioned the Federal Reserve for years to show multiple APRs for different periods, without success.  

In the absence of the obvious remedy, borrowers shopping different loan providers should ignore the APR and compare fees for a specified rate. Or they can go to my site where they can compare the total cost of competing loans over a future period specified by them.