Does Truth in Lending Help Borrowers?
February 5, 2001, Revised January 3, 2008,
February 5, 2011
Truth in Lending provides a small amount of useful information, but it is so interlarded with garbage information that few borrowers receive any benefit from it.
Truth in Lending (TIL) is a great idea gone hopelessly wrong.
The idea is to require lenders to provide one uniform set of price disclosures that is consistent from loan to loan and from lender to lender. Consumers can then compare prices across different loan types and different lenders. Unfortunately, the price information in the TIL makes little economic sense and is incomprehensible to most consumers.
When I comparison shop for a, e.g., $200,000 30-year fixed-rate mortgage, here is what I want to know:
In addition, I want a single measure of interest cost that takes account of both the rate and the upfront lender fees over the period I expect to have the mortgage. (Since the upfront fees must be spread over the life of the loan, my interest cost is lower the longer I expect to have the mortgage). This is the best measure to use in comparing different types of mortgages or in shopping mortgages from different sources.
If it was an adjustable rate mortgage, I would need more information -- see Information to Evaluate an Adjustable Rate Mortgage.
Assuming the same loan, here is approximately what I would find on the TIL:
The prepaid finance charge is a useful piece of information, but unfortunately the borrower has to know enough to calculate it by subtracting the amount financed from the loan amount, which is why I place it in brackets. This piece of arithmetic is also sometimes used to deliberately confuse the borrower, see Prepaid Finance Charges: Another Truth in Lending Lie?
The APR is supposed to be a shopping tool, but unfortunately it has serious flaws. First, it is calculated over the life of the loan, even though over 90% of all borrowers sell their house or refinance their mortgage before term. This can lead borrowers with relatively short time horizons astray.
Second, borrowers cannot safely assume that the APR on the day they lock the price will be the APR when they close because fixed-dollar fees are typically not included in the lock. See Why Isn't the APR Locked With the Rate?
Third, the APR cannot be used in comparing a cash-out refinance with a second mortgage. See The APR on a Cash-Out Refinance.
Fourth, the APR cannot be used effectively in comparing or shopping no-cost loans, or any loan in which the lender offers to pay the borrower's third part settlement costs in exchange for a higher rate, because the APR on such loan is biased. See Annual Percentage Rate Below Interest Rate on FRMs?
Fifth, the APR cannot be used effectively in comparing or shopping HELOCs because the APR on a HELOC is the interest rate. See How Do You Shop For a HELOC?
In the first version of this article, I said that the TIL is of some use in warning the borrower that the loan carries a prepayment penalty. That was before I realized how ineffective that warning was. See Disclosure Rules on Mortgage Prepayment Penalties.
Truth in Lending provides a small amount of useful information, but it is so interlarded with garbage information that few borrowers receive any benefit from it.
The Idea Behind TIL
Truth in Lending (TIL) is a great idea gone hopelessly wrong.
The idea is to require lenders to provide one uniform set of price disclosures that is consistent from loan to loan and from lender to lender. Consumers can then compare prices across different loan types and different lenders. Unfortunately, the price information in the TIL makes little economic sense and is incomprehensible to most consumers.
The Information I Need
When I comparison shop for a, e.g., $200,000 30-year fixed-rate mortgage, here is what I want to know:
Interest Rate: 7%
Total upfront lender fees expressed as a percent of loan: 1%, or $2,000
Total upfront lender fees expressed as dollars: $3550
Interest cost over the expected life of my mortgage (7 years): 7.53%
In addition, I want a single measure of interest cost that takes account of both the rate and the upfront lender fees over the period I expect to have the mortgage. (Since the upfront fees must be spread over the life of the loan, my interest cost is lower the longer I expect to have the mortgage). This is the best measure to use in comparing different types of mortgages or in shopping mortgages from different sources.
If it was an adjustable rate mortgage, I would need more information -- see Information to Evaluate an Adjustable Rate Mortgage.
Information on the TIL
Assuming the same loan, here is approximately what I would find on the TIL:
Total payments: $479,020. This is the monthly payment of $1330.61
multiplied by the term of 360.
Amount financed: $194,450. This is the loan amount of $200,000 less
prepaid finance charges of $5550.
Finance charge: $284,570. This is the sum of all interest payments over
360 months (total payments of $479,020 minus $200,000 of principal
repayments) plus the prepaid finance charges of $5550.
[Prepaid finance charges: $5550.]
APR: 7.28%. This is interest cost calculated over 30 years rather than
over the 7 years I expect to have my mortgage.
The prepaid finance charge is a useful piece of information, but unfortunately the borrower has to know enough to calculate it by subtracting the amount financed from the loan amount, which is why I place it in brackets. This piece of arithmetic is also sometimes used to deliberately confuse the borrower, see Prepaid Finance Charges: Another Truth in Lending Lie?
APR as a Shopping Tool
The APR is supposed to be a shopping tool, but unfortunately it has serious flaws. First, it is calculated over the life of the loan, even though over 90% of all borrowers sell their house or refinance their mortgage before term. This can lead borrowers with relatively short time horizons astray.
Second, borrowers cannot safely assume that the APR on the day they lock the price will be the APR when they close because fixed-dollar fees are typically not included in the lock. See Why Isn't the APR Locked With the Rate?
Third, the APR cannot be used in comparing a cash-out refinance with a second mortgage. See The APR on a Cash-Out Refinance.
Fourth, the APR cannot be used effectively in comparing or shopping no-cost loans, or any loan in which the lender offers to pay the borrower's third part settlement costs in exchange for a higher rate, because the APR on such loan is biased. See Annual Percentage Rate Below Interest Rate on FRMs?
Fifth, the APR cannot be used effectively in comparing or shopping HELOCs because the APR on a HELOC is the interest rate. See How Do You Shop For a HELOC?
In the first version of this article, I said that the TIL is of some use in warning the borrower that the loan carries a prepayment penalty. That was before I realized how ineffective that warning was. See Disclosure Rules on Mortgage Prepayment Penalties.