Consumers shopping for a mortgage
are frequently confronted with having to make a choice between complex
alternatives. For example, they can select an FRM on which the rate is
fixed at 5% for 30 years, or an
Annual Percentage Rate (APR)
To deal with
this problem, the Federal Government in the Truth in Lending Act decreed
that lenders had to disclose one number designed to be a comprehensive
measure of all costs, which they called the annual percentage rate, or APR. By
law, whenever a lender discloses an interest rate, they must disclose
the APR alongside it.
The Comprehension Problem: Developing a composite measure of
all mortgages costs was a great idea, but APR is the wrong measure. For
one thing, very few borrowers understand it. The APR is expressed as a
percent, same as the interest rate, except that the APR is somehow a
composite of the percentage rate and dollar costs. How they are combined
is a mystery to most. The mystery is even deeper on ARMs because the
Few loan
officers or mortgage brokers understand it either. Indeed, within most
lender firms, the only ones who understand how the APR is calculated are
the technologists responsible for having it programmed, and sometimes
they get it wrong.
The Comprehensiveness Problem:
Despite the intent, the APR has never been the
comprehensive measure of cost it was supposed to be. A comprehensive
measure would cover all costs that would not arise on an all-cash
transaction, but in practice third party charges are not covered. In
principle, this is an easy problem to fix, and the Federal Reserve in
recent proposals to amend its Truth in Lending regulations, has proposed
a fix. It has only taken them 30 years.
Borrower Differences in Time Horizon: The third
problem is more difficult. Cost depends not only on the characteristics
of the mortgage, but also on the characteristics of the borrower. A
given set of mortgage features may carry different costs to different
borrowers, but this is not reflected in the APR.
The most
important difference between borrowers is in how long they expect to be
in their house. The APR assumes they will be there for the full term of
the loan, which very few are. This can lead to bad decisions.
Consider a
borrower choosing between 2 30-year fixed-rate mortgages, one at 5.125%
and zero points, the other at 4.25% and 4.4 points. The first has an APR
of 5.125% while the second has an APR of 4.64%, suggesting that the
lower-rate mortgage is the better deal. But that is only because the APR
is calculated on the assumption that the borrower enjoys the lower rate
over the full term. If the borrower expects to be out in 5 years, the
APR on the low rate mortgage calculated over 5 years instead of 30 –
which I usually call the “interest cost” to distinguish it from the APR
-- would be 5.31%, and the higher rate mortgage would be the better
deal.
Because of
the built-in assumption that the borrower will have the loan for the
full term, the APR is also useless to borrowers assessing the cost of
adjustable–rate mortgages (ARMs). If the borrower expects to be out of
the house before the initial rate period is over, an APR calculated over
the full term may be misleading. If the borrower expects to have the
mortgage beyond the initial rate period, or isn’t sure, he needs to know
how much risk he faces from interest rate increases after the initial
rate period ends. But the APR doesn’t tell him that.
Borrower Differences in Tax Rate: A second
difference between borrowers that the APR does not account for is their
tax bracket; the APR is a before-tax measure. Because mortgage borrowers
can deduct interest payments and points from their taxes, any measure of
cost should be after taxes.
Borrower Differences in Opportunity Cost: A third
difference between borrowers that the APR does not account for is their
opportunity cost of funds. Because the upfront and monthly payments
required by the mortgage could otherwise be invested to yield a return,
that return is a cost to the borrower. For some borrowers who keep all
their money in savings accounts, the opportunity cost might be 1.5%. For
others who run businesses that always require capital, it might be 15%.
The APR implicitly assumes that the borrower’s opportunity cost is the
same as the APR.
Time Horizon Cost (THC)
An alternative measure of
borrower cost I call “time horizon cost” or
The
I am going to assume initially
that the borrower expects to be in the house 4 years, is in the 15% tax
bracket, and has an opportunity cost –the return he can earn on other
investments -- of 2%. The
Total monthly payments of principal and interest over 4 years: $23,613
Lost interest
on monthly payments: $803
Points paid
upfront: $4,400
Other
settlement costs paid upfront: $1,000
Lost interest
on points and other settlement costs: $380
Total costs:
$30,196
From these
costs, we subtract cost offsets:
The borrower’s
tax savings on points: $700
Reduction in
loan balance: $7,195
Total offsets:
$10,442
When we do
the same for the 5.125% mortgage, the total net cost is $18,768, or $986
less. The high-rate mortgage with zero points is the better deal.
But the
results are sensitive to the specific features of the borrower. If we
change the borrower’s time horizon from 4 years to 8 years, the results
are reversed, with the low-rate mortgage becoming the better deal
because the lower rate extends over a longer period. If we then raise
the borrower’s opportunity cost from 2% to 12%, keeping everything else
the same, the advantage flips back to the 5.125% mortgage because of the
larger interest loss on the points paid upfront. If finally we raise the
borrower’s tax rate to 40%, the advantage flips back once more to the
4.25% mortgage because of the larger tax savings on the points.
In using the
All the
numbers referred to above were drawn from calculator 9ci, which was
programmed to compare the THCs of different FRMs. Other calculators
compare different adjustable rate mortgages (ARMs), and ARMs versus
FRMs. Stand-alone calculators like mine, however, require the borrower
to enter the relevant prices. This is not nearly as useful to borrowers
as receiving THCs based on the prices actually being quoted to them by
loan providers.
One way that could happen would
be that the Truth in Lending Act is revised to replace APR with