Tuesday, November 1st, 2016
Whenever lenders disclose a rate quote, they must also disclose APR.
The reason for the central role of the APR is that it pulls together the interest rate and a wide range of origination charges into a single comprehensive measure of cost of credit to the borrower. The regulatory premise is that borrowers can use APR to compare loans of different types and features, and loans offered by different providers. If only it were true! For most borrowers, it isn’t…
Aside from lenders who omit APR related costs or use gimmicks to make their APR percentage look more attractive (like lenders who disclose only 1 day of per diem interest vs the industry standard 15 days), here are a few lesser known instances where APRs are either incorrect or misleading:
Borrowers Obtaining Lender Rebates
Many mortgage borrowers are attracted to loans carrying a slightly higher rate with ‘negative points,’ which are lender rebates rather than charges. These rebates are used to offset other closing costs including contributions to escrow accounts.
The problem is that the APRs reported by lenders on loans carrying rebates are not comparable. There is no clear rule regarding the treatment of rebates in the APR calculation, and different lenders do it in different ways.
Then a loan carries a lender rebate, the APR should be below the interest rate, but it’s rare to find a lender who can calculate it properly. In most cases, the APR on rebate loans was either equal to or higher than the interest rate.
Borrowers looking for lender rebates should ignore the APR and instead shop for the most negative points with lowest interest rate.
Borrower with Short Time Horizons
For borrowers who expect that they will sell their house or refinance their mortgage before the end of its term, the APR is not a dependable guide.
In allocating fees on a 30 year mortgage, for example, it stretches the fees over 360 months. Since very few mortgages actually run to term, the fee component of the APR is almost always understated.
For all borrowers except those who expect to hold their mortgage to term, the APR is biased in favor of loans with low interest rates and high fees, relative to loans with higher rates and lower fees.
This bias could be eliminated by making the time period used in the calculation “borrower specific” — calculated for each borrower over the period specified by the borrower.
In sum, the best way to compare different combinations of interest rate and other costs is to measure all costs over a period that is your best guess of how long you will have the mortgage.