Why is ‘annual percentage rate’ appearing higher than your rate?
If there is one thing I can count on, it’s a borrower getting glazed eyes when they see the “truth-in-lending” (or TIL as it is often referred to) form that comes with every loan closing.
This is undoubtedly the most confusing document a government committee ever came up with, although I will grant you the intent was good. The intent was to provide an interest rate that reflected the entire cost of the loan, including closing costs.
But like most government efforts, it ended up being a confusing mess that should be labeled the “confusion-in-lending” statement.
The TIL is used to demonstrate the government’s version of what they think a loan is costing you, and one must wonder if they use the same mathematical theories when trying to budget. The resulting calculation is called your “annual percentage rate” or APR.
How it works
Here’s how it works, at least as best I can explain the thought process that seems to have gone into this gem of a formula. Let’s say you are borrowing $200,000 to pay off your current loan of $200,000 on a 30-year fixed rate of 4.375 percent. You have $2,500 in closing costs and are paying a 1 percent origination fee of $2,000 for a total of $4,500. Your new rate is going to be 4.375 percent.
You, oh practical minded homeowner, plan to pay your closing costs out of pocket and bring a check for $4,500. You sensibly see at it as bringing a check for the $4,500 and borrowing the $200,000, which sounds logical and simple enough. You look at it as paying 4.375 percent on the $200,000 and indeed that is how the interest will be calculated.
But the feds don’t agree and think you would be a financial bumpkin for believing such fairy tales. Keep in mind this is the same bunch of financial wizards who have nearly cratered the world economy too many times to even count and somehow never noticed.
They see it as some of the $4,500 being “prepaid finance charges” (or PFC) and some of it as not. What defines a “PFC” is who the recipient is. If it’s the lender, then it’s a PFC. If it’s a third party such as a title company or appraiser, then it isn’t. So let’s assume on your loan that of the $4,500 in closing costs, the lender was getting $3,000 and the title company, appraiser and other third parties were getting the other $1,500.
So the feds say that the lender must assume that the borrower is actually borrowing $197,000 and in addition to the 4.375 percent interest, the $3,000 PFC closing costs must be averaged over the life of the loan. This means all the interest you will pay is divided into the $197,000 instead of $200,000 and results in the interest rate annualized at 4.553 percent.
Now to further muddy the water, as a mortgage broker I am required to charge you the origination fee of 1 percent, even if I’m going to give you a credit back to offset it, (which I do almost 100 percent of the time), and the credit doesn’t factor into the APR.
If you are borrowing money from a bank and not through a broker, then they seldom give you the credit back for the origination fee and in this example, could offer an identical APR, but the cost to the borrower would end up being $2,000 higher.
And if you have an adjustable rate mortgage, then you might as well use the TIL to light the fireplace with. That calculation not only includes the above mathematical eccentricities but assumes (in most cases) that your interest rate will decline every year the loan adjusts.
Moral of the story
My point of this story is that when you shop for a loan, don’t pay a moment of attention to the APR. You need to add up the closing costs, look at the interest rate and the payment. If the closing costs are way different, then you should take the difference of the monthly payments and divide it into the difference in the closing costs and see how long it would take you to save the extra closing costs back by having a slightly lower payment.
All mortgage lenders are required to give the consumer an APR on their loan, but the true costs of the loan seldom are reflected in the APR.
Chris Neuswanger is a mortgage loan originator with Macro Financial Group in Avon and may be reached at 970-748-0342. He welcomes mortgage-related inquiries from readers. His blog and a collection of his past columns are at http://www.mtn mortgageguy.com.