New Mortgage Rules Don't Fix APR Flaws

NEW YORK (TheStreet) -- What is APR, anyway? The "annual percentage rate" figure quoted on mortgages can be confusing, and government regulations that took effect Friday do little to make them clearer. As a result, an unwary borrower could easily choose the wrong loan.

That's the view of Jack M. Guttentag, emeritus finance professor at the University of Pennsylvania's Wharton School. On his website he describes the new APR tweaks, part of the Dodd-Frank reforms, as "largely useless" for achieving their goal of helping borrowers make apples-to-apples comparisons between loans with different combinations of interest rates and fees.

Not that solving the problem is easy. A key factor in comparing loans is how long the borrower expects to keep them, and even the borrower rarely knows for sure.

Generally, a borrower who opts to pay higher fees, such as "points," gets a lower mortgage rate in exchange, reducing the monthly loan payment. Obviously, if you keep the loan long enough, the savings on payments will offset the extra fees. The Mortgage Points Calculator shows how this works.

The APR figure is meant to provide this comparison at a glance. But the loan with the lower APR may not actually be cheaper if the borrower does not keep the loan for the full term, typically 15 or 30 years.

Guttentag describes a borrower choosing between two 30-year fixed-rate loans for $200,000. The first charges 4.375% and carries no fees, giving it an APR that is the same as the 4.375% loan rate. The second charges 3.375% but carries $19,000 in fees, for an APR of 4.19%.

At a glance, the second loan looks cheaper. But the APR calculation assumes 30 years of payments. If the borrower kept the loan for only five years, the lower payments on the "cheaper" loan would not have time to offset the huge fees. That would raise the APR on that loan to 5.67%. The borrower would have to keep the high-fee loan for 14 years to make that mortgage the less expensive choice.

This isn't rocket science, but it's a fact that borrowers can easily overlook by making snap judgments based on APR. It's a long-running problem that the new consumer-protection disclosures failed to address, Guttentag says. He says it could have been resolved by requiring lenders to figure APRs for several holding periods, or to calculate APR based on how long the borrower expected to keep the loan.

APRs on adjustable-rate mortgages can be even more deceiving, Guttentag says, because, in addition to assuming the loan is kept for the full term, they assume the initial "teaser" rate is good for the life of the loan. In fact, the rate is typically reset every 12 months after the end of the initial period, usually one to 10 years. The borrower's experience can be radically different from that implied by the APR figure, making APR all but useless.

What can the borrower do?

A borrower opting for an ARM should look at a worst-case scenario, which assumes the loan rate adjusts as quickly as possible to the maximum allowed in the contract. That will tell you whether you can afford the loan, and make it a bit easier to weigh the pros and cons of two ARMs with different combinations of rates and fees.

A borrower who chooses a fixed-rate loan should use ARM figures only as a starting point. Before choosing a loan, use the Mortgage Points Calculator to see which option is cheaper over various time frames that might apply to you. The Mortgage APR Calculator can figure APR for any loan. Keep in mind that, like the APR figures from lenders, it assumes you have the loan for its full term.

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