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What
you should know before applying for a Mortgage
Loan
A good tool to compare mortgage loans across different
lenders is the Annual Percentage Rate (APR).
The Federal Truth in Lending law requires mortgage
companies to disclose the APR when they advertise
a rate. It is designed to represent the true
cost of the loan to the borrower, expressed
in the form of a yearly rate. The purpose is
to prevent lenders from hiding fees and up front
costs behind low advertised interest rates.
However the APR is in fact a very confusing
number. Even lenders admit it is confusing since
it includes some, but not all, of the various
fees and insurance premiums that accompany a
mortgage. The rules for calculation of this
number have not been clearly defined, so APRs
vary from lender to lender and from loan to
loan, depending on which types of fees and charges
are included.
We do not recommend relying upon the APR as
an indicator of a loan product's value. The
APR calculation is based upon the assumption
that you keep your loan for the entire period
of the loan, say 30 years, which in reality
may not be the true hold period for a borrower.
In addition, the APR model is flawed in that
when a product is variable and tied to an index,
the index is assumed to never change. This obviously
is an invalid assumption that can lead again
to a number, which in fact can not be compared,
from one quoting source to another.
Finally, the APR won't tell you anything about
balloon payments and prepayment penalties and
how long your rate is locked for. So a loan
with a lower APR is not necessarily a better
loan. You can use APRs as a guideline to shop
for loans but you should not depend solely on
the APR in choosing which loan is best for your
needs, it is important to look at other factors.
Why Ask?
The first question to ask when applying for
a mortgage is "What is the annual percentage
rate?" and not "What is the interest
rate."
Cost Disclosure
Let's discuss what APR was meant to disclose
and how it should be used. Let's start with
a hypothetical mortgage of a 7.00% - 30 year
mortgage of $100,000 that has an origination
fee (commission) of 1½ points (1½%
of the loan amount or in this example $1,500)
and other fees of $2,500. Sound pretty good?
The APR is 7.409%. What happened to the 7.00%?
Mortgage Math
You are paying $4,000 to borrow $100,000. In
effect you are only getting $96,000, but will
pay back the full $100,000 with interest.
Another way to look at understanding the annual
percentage rate is: The $4,000 of fees in the
above example divided by 30 years is $133.33
per year of additional interest. What
happens if we pay this loan off in 5 years?
The APR jumps to 7.998%. The fees we pay are
spread over fewer years, increasing the costs
per year. The $4,000 in fees divided by 5 years
sky rockets to $800 per year of additional interest.
See if you can guess which is the lowest cost
loan:
Example # 1 - 30 year fixed rate mortgage loan at 6.875%
with 2½ points origination fee and additional
fees of $2,443
Example # 2 - 30 year fixed rate mortgage loan at 7.000%
with 2 points and additional fees of $1,943
Example # 3 - 30 year fixed rate loan at 7.125%
with 1½ points and additional fees of $2,143
The correct answer is Example # 1 with an APR
of 7.381%. Example # 2 and Example # 2 had APRs
of 7.403 and 7.500 respectively.
Let us apply reality to the above examples.
Fewer than 5% of all 30 year mortgages are kept
30 years. What if this loan is paid off in 5
years?
Give up? Example # 2 with an APR of 7.984%
#1 had an APR of 8.113% and #3 8.035.
When you shop for your next mortgage, what
is the first question you should ask? And if
THEY can't answer, before hanging up, tell THEM
that "the APR is the measure of all of
the costs of a mortgage expressed as an annual
percentage rate."
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