Is the Annual Percentage Rate (APR) a Useful Disclosure?

October 23, 2016

While the Consumer Financial Protection Bureau (CFPB) changed the mortgage disclosure rules substantially last year, it did not change the APR, which continues as the disclosure centerpiece. Whenever lenders disclose a rate quote, they must also disclose the 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 the cost of credit to the borrower. The regulatory premise is that borrowers can use the APR to compare loans of different types and features, and loans offered by different loan providers. If only it were true! For most borrowers, it isn’t.

Borrowers 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.

The APR combines fees paid upfront with interest paid every month. It does this by allocating the fees monthly over the future life of the mortgage, assuming the mortgage runs to term. In allocating fees on a 30-year loan, 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 smaller 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. Where the borrower has not yet been identified, as in newspaper ads, several APRs could be shown, e.g., 3 years, 7 years and term.

In the meantime, 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. You can do that on my site.

Borrowers Refinancing With Cash-Out

Borrowers using their house as collateral for raising cash often compare the cost of a cash-out refinance with the cost of a second mortgage. The APR on the cash-out alternative is biased, however, because it fails to take account of the 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.

For example, a borrower has a 3.5% mortgage with balance of $160,000 and needs to raise $20,000. The rate on a cash-out refinance for $180,000 is 4%, and if there are no fees, the APR is 4%. The rate on a second mortgage of $20,000 is 5% and if there are no fees, the APR is 5%. A comparison of APRs suggests that the cash-out refinance is cheaper, but it isn’t. The APR of 4% does not account for the 1/2% increase on $160,000 which would be avoided by selecting the second mortgage.

To make it comparable to the APR on a second mortgage, the APR on a cash-out refinance could be converted into a "net-cash APR" that compares the difference in payments between the old and new loan to the amount of cash received by the borrower. In the meantime, use my calculator 3d (Cash-Out Refi Vs Second Mortgage), which compares all the costs over a future period of the existing loan plus a second with the costs of the new cash-out refi.

Borrowers Obtaining Lender Rebates

Many mortgage borrowers are cash short and are attracted to loans carrying a high rate plus negative points, which are lender rebates rather t han 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.

When a loan carries a lender rebate, the APR should be below the interest rate, but in my various searches I have found only one lender who did it properly. In all the other cases, the APR on rebate loans was either equal to or higher than the interest rate.

Borrowers looking for a rebate should ignore the APR and shop for the largest rebate at a specified interest rate.

Borrowers Looking For a HELOC

A HELOC is a line of credit, as opposed to a loan for a specified sum, and it is always adjustable rate. The APR is defined as the interest rate.

The initial rate (and APR) on a HELOC is usually set at a promotional level for a few months. At the end of that period, the rate is reset to equal the prime rate, which is currently 3.25%, plus the individual lender’s margin on the HELOC. For example, if the introductory rate is 4% for 4 months and the margin is 5%, the rate and APR will jump from 4% to 8.25% in the fifth month.

Because lenders are very free in posting their introductory interest rates, an APR equal to the rate provides borrowers with no additional information.  In contrast, many lenders do their best to conceal the critically important margin, and they often succeed because the margin is not a required disclosure.

HELOC borrowers have to take care of themselves, and they do that by shopping the margin.

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