What is the Mortgage Loan APR and why should you care?

Brought to you by Kyle Jessop, MVB Mortgage

The Truth In Lending (TIL) document itself defines the APR or Annual Percentage Rate, in a bold large font, as “The cost of your credit as a yearly rate”.

The Department of Housing and Urban Development defines the APR as follows:

“A measure of the cost of credit, expressed as a yearly rate. It includes interest as well as other charges. Because all lenders, by federal law, follow the same rules to ensure the accuracy of the annual percentage rate, it provides consumers with a good basis for comparing the cost of loans”.

Thus when it comes to mortgages, it is easy to infer that the APR should allow consumers to compare one lender’s offerings versus another’s to determine the most competitive loan option over the life of the loan.  (i.e.  The lower the APR, the better the loan program).  However it is not always that simple, and here are a few reasons why:

• Not all lenders use the same inputs in their calculations.  For example, let’s assume that two lenders offered the same 4% rate, but lender A charges $1000 in fees with no lender credit, while lender B charges $2000 in fees with a $4000 credit (to the borrower).  In this example, lender B is actually $3000 cheaper in costs, but may have a higher APR depending on whether or not the credit is included in the APR calculation.  Doesn’t this defeat the purpose of the APR?

   

• Each APR will include the days of interest collected at settlement, however some lenders use 30 days, some use 15, and some use actual days.  For example, if you are getting a $300,000 loan at 4%, your daily interest is $32.87.  A lender that “estimates” 30 days of interest in their APR will be over $900 higher in fees than a lender that estimates 1 day of interest.  The actual settlement date will be the same for each lender, but the initial APR will be different.  If you are relying solely on the APR to choose between lender(s), are you making an informed decision?

   

• APRs can be very misleading when evaluating ARM loans as they assume that rates will be constant over a 30 year period.  Imagine a 5/1 ARM on a $300,000 loan with a start rate of 3%, caps of 2/2/5, and a margin of 2.25.  See below (*) for an explanation of these terms (caps, margin) and how ARMs adjust, but the takeaway in this example is that you get a lower rate for the first few (5) years, with the risk of the rates escalating (as high as 8%) from years 6 – 30.  The APR as calculated by our company in December of 2014 is 2.985%.  So what would you think if you received a 5/1 ARM amortized over 30 years, and your Truth In Lending document clearly stated in bold font that the “cost of your credit as a yearly rate” was 2.985%?  Would you expect your rate to be under 3% for the entire 30 years?

So why should you care about any of the above examples?  If the scores of questions directed my way is any indication, consumers may be relying too heavily on the APR number without having a complete understanding of what it represents.  When comparing lenders, you may be better off simply comparing lender fees, and/or finding someone that you can trust.

Hope you find this information useful.

(*) Explanation of ARM and terms:

An ARM (adjustable rate mortgage) typically spans a 30 year timeframe similar to a 30 year fixed rate mortgage.  However with an ARM the interest rate is fixed for a short portion, and then it can adjust every year thereafter.  For example a 5/1 ARM will be fixed for 5 years, and then the interest rate can adjust each year for the remaining 25 years.  The advantage of an ARM, compared to a fixed rate, is that it often has a lower starting interest rate.  The downside is that the interest rate can go up each year after the initial fixed rate period expires. 

Using the similar 5/1 ARM example, the interest rate could adjust in the 60^th month.   To determine if the interest rate would adjust, a fixed component (margin) determined before settlement would be added to a variable component (typically 1yr libor or 1yr treasury note) to determine the fully indexed rate.  Again citing the above example, the margin is fixed at 2.25%.  If the 1yr libor was trading at 1% in 5 years, the fully indexed rate would be 3.25% (2.25% +1%) and the interest rate would adjust from 3% to 3.25% for the next 12 months.  The following year (year 7), the highest the interest rate could go is 5.25% and at no time over the life of the loan could the interest rate go higher than 8%.  These maximum adjustments are determined by the “caps” (2/2/5), where:

• The first number states how much the interest rate can move in the first adjustment period (no higher than 5% (the start rate of 3% plus 2%).

• The second number states how much the interest rate can move at each annual change in years 7-30.  The interest rate can never move more than 2% from the previous year, and in most cases it can never go lower than the margin (2.25%).

• The third number lists how high the rate can go over the life of the loan (initial rate of 3% + maximum cap of 5% =8%).

Hopefully this brief overview gives some insight into how an ARM works.  Please don’t hesitate to contact me if you would like more detail or click on the card below for my website.