APR: Not All It’s Cracked up to Be
When I first discovered an interest in investing, I remember stumbling across the fact that lenders are required to disclose the annual percentage rate or APR when offering a loan. Little did I know then, that what I thought was a government protection wasn’t so transparent after all. Below we’ll explore why APR can be misleading and what a better option looks like.
The Concept
The Truth in Lending Act (TILA) was passed in 1968 in an effort to make borrowers more aware of the true cost of taking out a loan. For example, if you borrowed $1000 from me for one year and I charged you 10% interest you would expect to pay $100 in interest or $1100 total. However, I could make the loan look more appealing while still making $100 if I instead offered you an interest rate of 2% and then in fine print added that there’s an $80 processing fee. In this case, I’m making $20 in interest plus the $80 fee, which is still $100. But I can honestly say that the interest rate is only 2%.
Lenders do this all the time. They use fees as a way to maintain their profit while lowering the interest rate so as to make a loan more attractive to potential borrowers. The idea behind TILA and specifically its requirement that lenders publish the APR is that you would be able to see through that little trick. In our example, the first loan has a stated interest rate (an advertised rate) of 10% and the second has a stated interest rate of 2%. But both have an APR of 10%. Looking at it that way, it’s simple to see that the cost of the two loans is the same. In this case, knowing the APRs is a good thing.
So What’s the Problem?
The problem is that there’s still a loophole. In fact, there are two. The first relates to the fees. TILA requires lenders to disclose the fees that they charge, but that’s not the same as disclosing all the fees that you’ll pay. Keeping it simple, let’s say that the lender charges a single processing fee but that they also require you to get an appraisal. That appraisal, while still a cost to you, isn’t paid to the lender. It’s paid to a third party. Thus, when you look at the APR the appraisal fee will not be included.
The other problem is the assumption that you’ll hold the loan to the end of the term. The average home mortgage loan in the United States is 30 years. Yet most people won’t take 30 years to pay off the loan. Odds are that something will happen in that time. If for example you decide to move, you’ll sell your current home and use the money from the sale to pay off the current loan. Only then will you get a new loan for your new home.
This becomes an issue because when APR is calculated it assumes you’ll keep that original loan for the full 30 years. Lenders have no way of knowing if you’ll move after seven years, refinance after 12, or even die before the end of the loan term. As a result, the fees charged up front get spread out over the full 30 years. This makes their impact on what you actually pay less than if you had for instance, a 10-year loan. Here’s a simplified example.
Fee
Length of Loan
Amount Paid Per Year
$3000
10 years
$300
$3000
30 years
$100
The Alternative
The alternative is to calculate your effective borrowing cost. It’s definitely not something the average person is going to do, but if you want to know the true cost of your loan this is the way to do it. The effective borrowing cost includes all fees (both from the lender and third parties) and also considers how long you’ll have the loan.
I won’t go into the calculations here, but I do want to provide an example.
Loan Amount
$400,000
$400,000
$400,000
When Loan Paid Off
30 years
10 years
5 years
Interest Rate
3.5%
3.5%
3.5%
Points Paid
2%
2%
2%
APR
3.67%
3.67%
3.67%
Effective Borrowing Rate
3.67%
3.77%
3.96%
Notice how the APR stays the same regardless of when you pay off the loan. Lenders can use this fact to show you what appears to be a lower rate. However, a more accurate measure is the effective borrowing rate, which is higher when you pay off your loan faster.
Again, while most people will not go through the effort of calculating their effective borrowing cost, it’s still to your benefit before taking out a loan to have an idea of how long you plan to stay in your home.
The specifics will of course vary from case to case, but generally speaking if this is your new forever home then it may very well be to your benefit to pay higher upfront fees in exchange for a lower interest rate. But if you plan on living there for only a couple years, then avoiding the fees by paying a higher interest rate may be the better option.
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