June 2, 2014

For over 40 years, the centerpiece mortgage disclosure mandated by Truth in Lending (TIL) has been the Annual Percentage Rate or APR. Recently, administration of TIL has shifted from the Federal Reserve to the new Consumer Financial Protection Bureau (CFPB), which has developed a new disclosure form called the Loan Estimate. Beginning August 2015 this form will replace both the TIL and a sister disclosure called the Good Faith Estimate. While the Loan Estimate eliminates some junk from the two disclosures it replaces, it carries over the APR from the TIL without significant change. The APR thus retains its role as the centerpiece  of mandatory disclosures. 

The appeal of the APR is that it is a single measure of credit cost that includes both the interest rate and upfront loan fees charged by the lender. If loan fees are zero, the APR equals the interest rate. The higher are the loan fees, the larger is the APR relative to the rate. 

The purpose of the APR is to provide a single measure that borrowers can use to compare loans of different types and features, and loans offered by different loan providers. Unfortunately, however, the APR has so many limitations that the list of borrowers who cannot use it effectively is much longer than the list of those who can.

 Borrowers Who Expect to Have Their Mortgage Less Than 7 Years Should Ignore the APR: The APR is calculated on the assumption that the loan runs to term, which means that on a 30-year loan the fees are assumed to be paid out over 30 years. If the loan is actually paid off within 7years, as most are, the APR understates cost to the borrower, and the higher the fees the larger the understatement.  

I railed at the Fed for 40 years and at CFPB for 3 years to show the APR calculated over the period specified by the borrower -- or at least to show several APRs for periods of different length – but it never happened and probably never will. As things stand, only borrowers with long time horizons should pay attention to the APR. 

Borrowers Who Are Refinancing to Obtain Cash Should Ignore the APR: The APR fails to take account of the interest rate on the old mortgage that is refinanced. If the rate on the old mortgage is below the rate on the new larger mortgage, failure to account for the loss of the lower rate can falsely suggest that the cash-out refinance will cost less than a second mortgage that raises the same amount of cash. 

A safe way for borrowers to compare the costs of a cash-out refinance with those of a second mortgage is to use calculator 3d on my web site.

Borrowers Who Need a Rebate From the Lender to Meet Their Cash Needs Should Ignore the APR: When borrowers pay positive points and/or other fees, which is the usual case, every lender calculates the APR in the same way. The APRs in such cases are always higher than the interest rates. But on high-rate loans on which lenders pay rebates that cover some or all third party fees, there is no clear-cut rule on how to calculate the APR.  Different lenders do it in different ways, which means that their APRs are not comparable. Note that cash-short borrowers shopping for a no-cost loan don’t need an APR. They can shop for the lowest rate. Their major concern is that “no-cost” be defined in the same way by all loan providers, an issue I will be writing about shortly.

Borrowers Who Need a HELOC Should Ignore the APR: A HELOC is an adjustable rate line of credit, with the rate reset monthly at the current level of the prime rate plus a margin which varies from loan to loan. The critical variable to the borrower is the margin, which is not a required disclosure.  The APR on a HELOC is the initial interest rate, which the borrower already knows and which may be misleadingly low if the loan has an introductory rate for a few months that is below the prime rate plus the margin.

Borrowers With Long Time Horizons Choosing Between an FRM and an ARM May Find it Useful to Compare Their APRs: The APR on an ARM takes account of the initial interest rate and the period for  which it holds, the current value of the rate index, the margin, and rate caps. Borrowers often don’t have this information, or don’t know what to do with it if they do have it. The APR is a valid measure of the cost of the ARM over its life on the assumption that the rate index to which the ARM rate is tied remains constant. If interest rates are higher at the end of the initial rat e period, the ARM APR will turn out to be too low, and vice versa.  

The APR on ARMs would be even more useful to the borrower if the no-change APR was supplemented by a worst-case APR, based on the assumption that the ARM rate rose to the maximum extent allowed by the ARM contract. This would show the borrower the highest cost possible with the ARM. While I see no possibility that the CFPB will do this anytime soon, I have asked my programmer to revise the ARM APR calculator on my web site (number 17) to add a worst case scenario to the results.  It will be available in June.