Congress, with the best of intentions enacted the Consumer Protection Act (commonly known as the Truth in Lending Act) in 1968 with the best of intentions. The act set out guidelines requiring lenders to disclose all the costs related to financing to the consumer. So bankers and other lenders set to work to confound the situation by quoting one interest rate, say 9%, and then disclosing that the Annual Percentage Rate or APR is, in truth, 9.38%, something above the quoted 9%. In fact the APR is always greater than the advertised interest rate. This bit of confusion is not limited to banks but extends to credit card issuers, mortgage lenders, in fact anyone in the business of lending money. Lenders are in the business of lending money at a profit. In order to induce a borrower to use a particular bank's services, for example, the interest rate is displayed in large typeface. Of course, the APR will also be displayed, it has to be, but in small print near the bottom of the page. Of course, if you do not deposit money in the bank, they have nothing to lend. So banks want to make your deposits sound quite attractive. If the bank pays 4% interest compounded monthly, then they will advertise an Annual Percentage Yield or APY at 4.074%. The APY, like the APR is always higher than the base percentage rate. Unfortunately the best intentions often are not realized. What should be a straightforward APR calculation that includes all the costs of the loan has become a draconian and often deceptive practice that may, in fact do more harm to consumers that the good that was originally intended. Calculating the APR for any loan, but especially for mortgage lending, is so complex that it requires specialized software and even after the calculations are done, many people in the industry can not fully explain what the calculation means or what was included in the total cost. APR is intended to include all of the costs attached to borrowing money. In the case of mortgages, however, not all the fees charged are included in the APR calculation. Furthermore, no weight is attached to tax consequences, especially when the lender offers a lower rate but higher fees. Finally, the APR includes fees and expenses over the life of the loan, that you will own the home for the full 30 years of your mortgage, pay it off and own your home outright. The problem here is that the average homeowner only holds on th the property for around 4 years. This distorts APR. Let's look at a practical example. Say Big Bank is offering a mortgage at 6.375% APR with a $2,500 fee. Good Bank is offering the same mortgage at an APR of 6.68% but is charging no fee. Big Bank's offer looks much better on the surface...but is it? Let's say you borrow $165,000. Big Bank's monthly payment is $1,015 but remember, you paid a $2,500 fee up front. Your payment on the same loan with Good Bank is $1,042 or $27 higher than Big Bank. But now calculate the recovery time needed to recoup your $2,500 fee. Divide $2,500 by $27 and you get a bit less than 93 months or 7.75 years. Considering that the average length of a mortgage is only 4 years, the Big Bank loan does not look so good any more. Of course, another important consideration is that the fees paid upfront in a mortgage transaction are not tax deductible whereas the additional $27 paid per month is fully deductible if you itemize your taxes. The whole point of this piece is to heighten awareness of APR and the pitfalls you may encounter if you rely solely on the APR as the most important factor in your decision making. You must always too the math and ask questions about anything you do not fully understand.
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