APR calculation can mislead loan shoppers

     By Jim DeBoth
     Mortgage Market Information Services
      Many borrowers are puzzled by the two rates they see when looking at advertisements for mortgage rates. First is the note rate offered, such as 6.25 percent; then there is the APR, which stands for the annual percentage rate.
      The annual percentage rate combines the note interest rate along with other costs of the loan into a single figure that shows the true annual cost of borrowing with that loan offer. These other costs factored in include the finance charges, therefore the APR is usually somewhat higher than the note rate.
      The lender is required by law to disclose the APR for loans, providing consumers with an easy way to compare lenders' loan programs. However, many industry participants feel this gauge is misleading and doesn't adequately allow consumers to do effective cost comparisons.
      The fees involved in originating any real estate loan are generally known as closing or settlement costs. They can cost several thousand dollars and include items such as the points paid, escrow costs, appraisal costs, the premium for private mortgage insurance and prepaid interest.
      The federal Truth-In-Lending law requires that lenders prorate, or assess proportionately, settlement costs over the life of the loan. This means that the costs are included in the loan amount. The government formula for figuring the APR is not widely known to the consumer public and can be a little tricky.
      If a home buyer borrows $200,000 at 7 percent interest, the monthly payment for a 30-year fixed-rate loan will be $1,330.60. The closing costs that apply to the APR calculation come to $4,000. The borrower pays this amount in cash at the loan closing, and gets a $200,000 loan to pay for the home purchase.
      The APR, as required by the Truth in Lending Act, measures the cost of borrowing based on the net loan amount received by the borrower. To calculate the APR, relevant loan costs, in this case $4,000, are deducted from the actual loan amount, in this case $200,000. What remains is the "net funds" that the borrower is receiving to purchase the home. In this case the borrower is actually only receiving net funds of $196,000 (since he or she had to pay $4,000 in order to receive a $200,000 loan).
      The interest rate is then recalculated assuming the loan payment of $1330.60 and the net loan amount of $196,000. This recalculated rate is the annual percentage rate. In this example the APR would be calculated at 7.20 percent.
      Although required by law, the APR is the subject of much controversy in the lending industry. Many claim there is a fatal flaw in the calculation process. To be certain, several items are not included in determining the APR.
      The APR formula includes certain loan costs that are payable by the borrower in connection with the loan. This would include major costs such as broker's fees, origination fees and discount points (all of which are usually based as a percentage of the loan amount); loan processing and underwriting fees; prepaid interest; and any mortgage insurance premiums that may be required. Other nonstandard fees charged by a lender may also be included in the calculation of APR. If such fees are to appear on Section 800 or Section 1300 of the standard HUD-1 or HUD-1A settlement statement, they may be included.
      Other costs may be due at the closing, but are not included into the calculation of APR. These would include any title-related charges (title insurance, title search, document preparation, closing fees); a prepaid hazard insurance premium; escrowed items (for real estate taxes and insurance); attorney and recording fees; the notary fee; and prorated transfer taxes, if any.
      After figuring all these fees, here's the problem, or "fatal flaw" as California mortgage broker and author Randy Johnson puts it.
      "The formula makes the patently false assumption that each loan will run its full term of 15 or 30 years," Johnson said. "In fact the life of nearly all loans is much less than that."
      Many people sell their home or refinance their loan after a few years. Johnson pointed out that shopping for the lowest APR offered by a lender or broker doesn't make any sense because the formula is flawed.
      "Rate shopping, gets more borrowers in trouble faster than anything else, especially since the APR doesn't really mean much," he said.
      On short-term debt for items such as cars or refrigerators, he said, "the APR makes sense, because these loans are usually paid out as scheduled. However, to use the APR formula for a 30-year loan that may be on the books for five to seven years makes no sense at all."
      The law requires that the APR figure be disclosed, even though it will not affect the monthly payment and the interest rate is the note rate of the loan.
      The reason this came up at all was because regulators believed that some lenders and brokers were not disclosing all involved fees to borrowers, which was true. Any business involving money and property attracts people who take advantage of those who don't really know the system. Making the annual percentage rate disclosure part of the law was meant to limit that behavior.
      "Maybe it has, " said Larry Silvas, a central California loan officer. "However, its irrelevance makes it deceptive to the consumer. The borrower needs to learn to compare programs first rather than APRs. For example, the APR can be all over the map simply because prepaid interest can run from zero to 30 days. You don't know what's assumed in the APR quote, or even if it was correctly calculated."
      Indeed, conversations with several other brokers reveals that not everyone calculates the APR the same way.
      "Twenty lenders control 70 percent of the mortgage market and their cost of money is virtually the same," Johnson said. "Service is what one should shop for, not rates. Good service, which means finding the right program for each situation, as well as the best rate, is worth an eighth of a point anywhere. Finding the absolute rock bottom, cheapest rate does not necessarily mean you have the best loan or the best lender."
      The APR may help to keep more lenders in line, but it doesn't really solve all the consumer's questions about mortgage rates. When comparison shopping for a mortgage loan, a consumer should ask lenders to quote rates based on zero discount points. This will help make an `apples to apples' comparison a little easier. Another good question is to ask the lender what major loan-related fees are charged. Many lenders will provide a Good Faith Estimate of closing costs without having to apply for a loan first.
      --Jim De Both is president of Mortgage Market Information Services -- a national publisher of mortgage rates and information.