APR Can Cost You

APR is often brought up as many people are “taught” to look at APR to get an apples-to-apples comparison between loans. The truth is, there is a bigger picture that gets missed by fixating on APR alone, and it can cost you a lot of money! The following article by Barry Habib, Contributing Editor to CNBC.com, explains how.

light on aprA borrower who is shopping for the best mortgage rate can easily be seduced by low rate offers that are accompanied by low Annual Percentage Rates (APR). Federal Law requires that APR be disclosed along side the actual interest rate…this is in order to help borrowers make a more informed decision on their mortgage. The truth is that APR is a very poor way to comparison shop for a mortgage and can cause borrowers to make costly wrong decisions.

APR was created in order to provide a way for borrowers to account for costs associated with the mortgage. This sounds good because it may not be very easy to choose between a loan with a lower rate and higher fees or a loan at a higher rate and low fees. The problem is that the APR calculation makes some very bad assumptions. First, APR assumes zero inflation and that the value or buying power of a Dollar today will be exactly equal to the value of a Dollar 10, 20 even 30 years from now. Next, the APR calculation assumes that the mortgage will never be prepaid or paid off. That means no refinancing or selling the home…highly unlikely since the average life of a home mortgage loan is less than four years. Just think, about your own clients. Is it not rare to see the same loan in place for even 5-years…forget 30-years. The APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it were not spent on closing costs. Finally, APR does not take tax consequences into consideration. This can be significant since higher fees on the mortgage may not be deductible while the higher interest rate typically is deductible. Moreover, APR can be manipulated, making it totally worthless.

So how does APR work anyway? I like to explain it to my clients by using triangles. I often draw two sets of triangle for my clients to illustrate the difference between Interest Rate and APR. The reason for the triangle is because there are 3 sources of input…”Interest Rate”, “Mortgage Amount” and “Monthly Payment”. If you know any two of the three, you can calculate the third. See the triangle below.

triangle

Since any two of the three variables allows you to calculate the third, a $911 monthly payment for a $150,000 mortgage calculates to an interest rate of 6.125%. But the APR calculation uses different information. The APR calculation only keeps the “Monthly Payment” information the same. Instead of the “Mortgage Amount”, APR uses “Amount Financed”. This is the “Amount Financed” information on the Truth in Lending statement. Amount Financed takes into consideration the fees that are lender imposed. This includes application fees, points, commitment fees…and interim or per diem interest. So, Amount Financed is the mortgage amount less any lender fees, points and interim interest. The more fees, the lower the Amount Financed. The monthly payment is then calculated as a product of the Amount Financed to give you the “Annual Percentage Rate” or “APR”. So the lower the “Amount Financed”, the higher the “APR” is. Amount Financed can be manipulated by assuming a closing on the last day instead of the first day of the month. That would increase the Amount Financed and decrease the APR.

Lender A

Here is a real example on a $150,000 fixed rate 30-year mortgage with zero points: Lender “A” (triangle above) is offering a great low rate of 5.875% and lender “B” (triangle below) is offering a higher rate of 6.125%.

Lender B

A closer look shows that Lender “A” is charging $3,000 more in fees than Lender “B”. How do you compare? If you look at APR, Lender “A” (5.875% with $3,000 higher fees) has an APR of 6.149%. Lender “B” (6.125% but a $3,000 savings in fees) has an APR of 6.211%. So according the APR, Lender A is a better deal even though the fees are $3,000 higher…this is exactly what these high fee lenders are hoping you look at.

Let’s look at the real story. The payment difference between the two is $24 per month. So is it worth paying $3,000 in fees to Lender A in order to save $24 per month? Hardly. It will take 10.5 years for a borrower to just to get back their investment! A bad choice when you consider that mortgage loans typically are retired within four years. To make the decision to go with Lender “A” even worse, if that’s possible, borrowers rarely take the value of today’s dollars into account. Rather than giving Lender “A” the windfall of your hard earned $3,000, you should give it to yourself. Reduce the loan balance on your mortgage by the fees you are saving. In the example above that would reduce the loan from $150,000 to $147,000. This makes the payment difference just $6 per month instead of $24 per month! The true time to break even is really 500 months (more than 40-years!). So it is impossible to benefit from the higher fee program from Lender “A” because the maximum period on the loan is 30 years or 360 months. One more thing…when you calculate your tax deduction on the payment difference, it makes even more sense to avoid paying higher non-deductible fees. The obvious correct choice is to go with Lender “B” even though the APR is lower with Lender “A”.

Bottom line…your clients should forget APR and think twice about those advertised low rates when they are accompanied by higher fees. Use the above illustrations to drive your point home.

Mortgage rates fall for 7th week in a row

By Polyana da CostaBankrate.com

Mortgage rates dropped slightly this week amid weak economic results in the United States and growing concerns that the European debt crisis is worsening.

Mortgage rates for May 25, 2011

The benchmark 30-year fixed-rate mortgage fell 2 basis points this week, to 4.75 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week’s survey had an average total of 0.4 discount and origination points. One year ago, the mortgage index was 4.92 percent; four weeks ago, it was 4.95 percent.

The benchmark 15-year fixed-rate mortgage fell 2 basis points, to 3.93 percent. The benchmark 5/1 adjustable-rate mortgage fell 3 basis points, to 3.45 percent. Fixed mortgage rates have dropped for seven weeks in a row, according to Bankrate.com’s surveys. This is the lowest rate on the 30-year fixed in more than five months. On Dec. 1 the rate was 4.71 percent, according to Bankrate’s survey.

Weekly national mortgage survey

Results of Bankrate.com’s May 25, 2011, weekly national survey of large lenders and the effect on monthly payments for a $165,000 loan:

30-year fixed 15-year fixed 5-year ARM
This week’s rate: 4.75% 3.93% 3.45%
Change from last week: -0.02 -0.05 -0.03
Monthly payment: $860.72 $1,214.71 $736.33
Change from last week: -$1.99 -$1.64 -$2.75

Weakening economy

Signs of a weakening U.S. economy have contributed to keeping rates low, says David Adamo of Luxury Mortgage in Stamford, Conn.

One of those signs was the April durable goods orders data released Wednesday by the Department of Commerce. The report measures consumer and business spending on long-term purchases such as cars, planes, computers, appliances and other durable items. Orders for those types of products decreased 3.6 percent in April, according to the department. That’s worse than the 2.2 percent drop that economists had expected.

Part of the drop can be explained by the impact of Japan’s earthquake on manufacturing industries, but the decrease is still viewed as a clear sign that consumers and businesses are struggling and are putting off major purchases, economists say.

Until economic reports begin to show the economy is recovering and growing, it is unlikely mortgage rates will see any big spikes, Adamo says.

“Whenever you have a lot of negative events, the market sees a flight to quality,” he says.

That flight to quality happens when worried investors pull out of riskier investments, such as stocks, and put their money into bonds. As demand for U.S. bonds increases, yields drop, and that normally translates into lower rates.

This week, investors sought safety in the U.S. bond market as they watched stocks for many major companies fall. Most of the drops in the U.S. stock market were seen in consumer stocks, such as those for clothing and food companies. Polo Ralph Lauren Corp., American Eagle Outfitters Inc. and Kraft Foods Inc. were some of the many companies that saw their stock drop this week.

Growing concerns over Europe’s debt crisis

Investors also have been pulling out of the European bond market as they grow concerned that Greece’s debt woes will spread to European countries, including Spain and even Italy.

Greece’s bonds have plunged on speculation that Greece will not be able to restructure its debt and will eventually default.

“The U.S. mortgage market is a player in the global market, and we are certainly getting help from the eurozone,” says Dan Green of Waterstone Mortgage in Cincinnati. “Money flows from country to country and market to market. Right now, the money is flowing into the U.S.”

But don’t assume that mortgage rates will remain low until the Europeans are able to figure out their financial problems, Green says.

“So many things are unknown,” he says. “Any major unexpected event could be a shock to the system and immediately impact rates.”

Positive News! (video update)

With all of the negative headlines out there, I thought I’d share highlight some positive news this week.  The Pending Home Sales Index, a forward-looking indicator, rose over 10%.  FHA has extended condominium project approvals that were previously due to expire on December 7, 2010.  To look up condo expiration dates in your area use this site: https://entp.hud.gov/idapp/html/condlook.cfmVideo Update 12/14

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