February 5, 2001
"How does Truth in Lending
help mortgage borrowers?"
It doesn�t. Truth in Lending (TIL)
is a great idea gone hopelessly wrong.
The idea is to require lenders to
provide one uniform set of price disclosures that are consistent from loan
to loan, and from lender to lender. Then consumers can compare prices
across loan types and across lenders. Unfortunately, the price information
in the TIL makes little economic sense and is incomprehensible to most
consumers.
When I comparison shop for a,
e.g., $200,000 30-year fixed-rate mortgage, here is what I want to know:
Interest Rate: 7%
Total upfront credit charges
expressed as a percent of loan: 1%, or $2,000
Total upfront credit charges
expressed as dollars: $3550
Interest cost over the
expected life of the mortgage (7 years): 7.53%
I want the interest rate because
that determines my credit cost every month I have the loan, and I want the
credit charges because that�s what I must pay out of my pocket now. The
breakdown of credit charges between those expressed as a percent of the
loan and those that are a fixed number of dollars tells me how much more
or less I would pay upfront if I change the loan amount.
In addition, I want a single
measure of interest cost that takes account of both the rate and the
upfront credit charges over the period I expect to have the mortgage.
(Since the upfront charges must be spread over the life of the loan, my
interest cost is lower the longer I expect to have the mortgage). This is
the best measure to use in comparing different types of mortgages or in
shopping mortgages from different sources.
If it was an adjustable rate
mortgage, I would need more information, but I�ll leave that for another
day.
Assuming the same loan, here is
approximately what I would find on the TIL:
Total payments: $479,020.
This is the monthly payment of $1330.61 multiplied by the term of 360.
Amount financed: $194,450.
This is the loan amount of $200,000 less "prepaid finance
charges" of $5550. This assumes that prepaid finance charges include
all upfront credit charges, which is not in fact the case as explained
below.
Finance charge: $284,570.
This is the sum of all interest payments over 360 months (total payments
of $479,020 minus $200,000 of principal repayments) plus the prepaid
finance charges of $5550.
APR: 7.28%.
This is interest cost calculated over 30 years rather than over the 7
years I expect to have my mortgage.
The first 3 numbers are totally
useless for comparing loans of different type, or for shopping different
loan providers. For example, the "finance charge" gives the same
weight to dollars paid in interest in the 30th year as dollars
paid at closing. TIL doesn�t show the interest rate, probably because of
a presumption that the APR makes it unnecessary.
The APR is supposed to be a
shopping tool, but unfortunately it has serious flaws. While logic
dictates that all upfront charges that a borrower would not have in an
all-cash transaction should be included in the APR, this is not the case.
Fees covering such items as credit reports, appraisals, document
preparation, and pest inspections are excluded by most lenders, although
not by all. I have found numerous inconsistencies between lenders in what
is and what is not included in the APR.
The second deficiency of the APR
is that it is calculated over the life of the loan, even though over 90%
of all borrowers sell their house or refinance their mortgage before term.
This can lead borrowers with relatively short time horizons astray.
For example, suppose my $200,000
30-year loan at 7% plus $5500 is also available at 6.5% and $11,500. Which
is better? The APRs calculated over 30 years are 7.08% for the 6.5% versus
7.28% for the 7%, suggesting that the 6.5% loan is better. But calculated
over 7 years, interest cost is lower on the 7% loan � 7.53% versus
7.61%.
But the TIL is not totally
worthless. It warns you if there is a prepayment penalty on your loan. It
doesn�t tell you what it is, but it warns you, which is a good thing. If
I sound cynical, it�s because I am.
Copyright Jack Guttentag
2002
