by Robert E. Bodine, Esq. and Dan Kotz, Esq.
The Truth in Lending statement (“TIL”) is a part of the real estate closing package that creates the most confusion for borrowers. The source of the confusion is the much-maligned Annual Percentage Rate (“APR”). In fact, the APR, if it were understood by the average borrower, could be a very useful tool for comparing the value offered by different loans. In this article, we explain what exactly the APR is and why it’s important.
What is So Confusing About the APR?
The APR is “much-maligned” because it looks like your interest rate, but for fixed rate loans it’s almost always larger, which has some borrowers thinking that the lender is raising their rate at the last minute. To make matters worse, most borrowers don’t understand it, so no matter how much they’re told it’s not their “real” interest rate, it continues to leave them unsatisfied. This is a shame because it’s really easy to explain by using straightforward examples, though the explanation does start with some confusing terms.
What Is the APR?
The APR is a composite number, combining the interest rates with the closing costs to arrive at a number that appropriately represents the cost of the loan.
When a lender proposes a loan, the loan comes with an interest rate, but also with closing costs (e.g., origination fee, credit report fee). Some of those closing costs are the same regardless of who the lender is (e.g., taxes), but some costs are the normal lender service charges representing the cost of doing business. Obviously, as with any service provider, that second group of charges will vary from lender to lender. So, if ABC Mortgage offers a 2% interest rate on a 30-year, $300,000 loan, the immediate instinct is to assume they’re giving a great deal. However, what if ABC Mortgage is charging $1,000,000 in closing costs? Clearly, those closing costs are ridiculous, and the borrower should probably shop around for a better deal. The problem, of course, is that usually the numbers are much closer, and thus harder to evaluate.
So, what if Wells Fargo offers a 30-year, $300,000 loan with a 5% interest rate with $2,000 in closing costs, Bank of America offers a 30-year, $300,000 loan with a 4.9% interest rate with $6,000 in closing costs, and Suntrust offers a 30-year, $300,000 loan with a 4.95% interest rate with $5,000 in closing costs (chart below)? Which represents the best deal? Clearly, over time, the 4.9% interest rate is better, because there’s less interest paid, but is it so much better that it’s worth the extra $3,000 or $4,000 paid in fees? How does a borrower compare these two loans without a college degree in mathematics?
The borrower doesn’t. The APR provides the answer instead. The lender factors in the closing costs into the interest rate, creating a new interest rate, the APR. The result is an interest rate that’s almost always going to be higher than the actual interest rate unless your closing costs are $0. This higher number often concerns borrowers, but keep in mind that the payment amount is based on your actual interest rate. The APR has no actual effect on the loan, instead simply demonstrating whether one loan costs more than another.
For the examples above, here are the results (care of http://www.debtconsolidationcare.com/calculator/apr.html, last visited August 21, 2012):
|Wells Fargo||Suntrust||Bank of America||ABC Mortgage|
|Term (how many years)||30-years||30-years||30-years||30-years|
So in these hypothetical cases, Bank of America is offering \the best deal. This is interesting in that they’re charging three times as much up front as Wells Fargo. Not surprisingly, though, getting a lower interest rate is far more important than closing costs to getting the best deal, though it’s not the entire picture. Suntrust has a lower interest rate than Wells Fargo, but it’s still better to go with Wells Fargo based on the APR. ABC Mortgage, on the other hand, is clearly a scam artist.
TMI: How Is It Calculated?
It’s not necessary to know how the APR is calculated to understand what’s written above, but for those that want to know, it’s provided here. Using the Bank of America loan as an example, the TIL for that APR would have a table at the top of the statement that looks like this:
Percentage Rate 5.0738%
|Total of Payments
You have the APR, the total amount of interest payments over 30 years, the amount financed, and the total amount of all payments over 30 years. The 2nd and 4th numbers make perfect sense. If the borrower pays $584,657.20 over 30 years, and of that $284,647.20 is interest, then the difference should be the “principal” paid (i.e., the loan amount). Sure enough, the difference is $300,000.00, the exact amount of the loan.
Now let’s dig a little deeper. There’s a complex mathematical relationship between the interest rate (5%), the loan amount ($300,000.00), and the total number of payments made over 30 years. If we change any one of those numbers, at least one of the other numbers must change to keep the equation balanced. Well, the total amount of payments is not going to change, so that remains constant. This means that if we change the loan amount, then the interest rate must be what changes to keep the equation balanced.
Notice that the Amount Financed of the loan is $294,000, which is the loan amount ($300,000) minus the closing costs ($6,000). So the “loan amount” is decreased, which means the “interest rate” has to increase in order to keep the Total of Payments constant. This new interest rate is the APR. The higher the closing costs, the lower the Amount Financed will be, which means the higher the “new” interest rate will be. In this way, we calculate the “new interest rate,” the APR, which is related to both the real interest rate and the closing costs.
That’s what the APR is and how it’s calculated. We hope that’s clear. Whether or not the calculation is clear, three things should be.
- The APR is a “fake” number. It’s not your real interest rate. You haven’t been duped by your loan officer into a hidden interest rate increase.
- The closer the APR is to your real interest rate, the lower your closing costs must have been.
- The APR is the best way to compare what different lenders are going to charge you for the loans they’re offering you.
Also, you might not want to pay $6,000 up front in closing costs. That’s understandable. You might have very good reasons for wanting to pay more for your loan. The APR is simply there to tell you what the cost of your loan is, thus allowing a proper comparison between different loans offered by different lenders. Hopefully, it’s now a little less confusing.