APR: Just One Part of the Mortgage Machine

One of the reasons why we have the federal Truth in Lending Act (TILA) was to help consumers gather enough information to make an informed decision on the cost of a mortgage loan.

Annual Percentage Rate, or APR is defined as the total cost of credit to the consumer expressed as an annual percentage of the amount of credit granted. APR is intended to make it easier to compare lenders and loan options.

TILA directs lenders to compute their APR using the actuarial method OR the US method. “Either method is fine,” says mortgage industry consultant Gordon Schlicke, “and both are very long, complex math equations if done by hand.” Today, we all use computer software pre-programmed to compute APR.  The actuarial method and the U.S. method will result in different APRs. This is fine because TILA allows for variances in APRs: .125 (1/8)% on fixed rate products and .25 (1/4)% on adjustable rate products.

The APR is computed on the amount financed, which is the loan amount LESS prepaid finance charges.

HUD provides suggestions for how to define prepaids.  However, our federal government also understands that different areas of the country have different local customs and lending practices so HUD allows each lender to choose how they define prepaids, but ONLY if the lender receives legal counsel to that effect.  So, for example, Lender X wants to define prepaids in their own way.  They receive legal counsel in the form of a letter on file as to how they are defining prepaids based on local custom.

So we started with a great federal law intended to help consumers become better informed as to how much a loan will cost the consumer. What we end up with is a wide variety of ways to compute APR, all of which are allowable.

Shopping for loans only using APR is a mistake. Shopping for a mortgage loan and only focusing on one piece of a mortgage loan is a mistake.  Consumers who only focus on the note rate or monthly payment and who ignore the other many moving parts of a mortgage are very easy consumers to take advantage of.  Until higher standards are in place regulating the ethical conduct of mortgage loan originators, at minimum, a consumer ought take a look at the whole picture of a mortgage loan and how it works, from the perspective of a traditional fixed rate mortgage before deciding how a mortgage product fits in with a consumer’s tolerance for risk and the tax advantages of the many, many creative mortgage products being sold in today’s market beyond the traditional fixed rate products.

Consumers, when shopping for a mortgage, don’t focus only on ONE of these pieces, instead look at the whole machine:

Monthly payment

Loan product


Closing costs

The originating lending institution

The institution to which your loan will be sold

The ancillary service costs including appraisal, title credit, escrow, and so forth

And finally, the individual people working inside these institutions providing all these services most notably, your mortgage loan originator.

Obtain a Good Faith Estimate from at least three types of institutions: your favorite local bank, a mortgage broker, and a credit union. If anyone out there from a licensed consumer finance company can make a case for why you ought to be on my list of recommended institutions, please enlighten us via posting a response. 

2012 update: That last sentence was part of the original 2007 blog post when we were seeing large, national predatory lending cases at consumer finance companies such as Household Finance and Ameriquest.  With state and federal law changes, many mortgage broker loan originators have switched over from working under a mortgage broker to….the consumer finance company licensing system. We could also refer to these types of companies as “non-depository lenders,” or “non-bank lenders.”  They loan mortgage money but do not offer checking and savings.  These non-bank lenders now make up a huge market share of all the companies originating mortgage loans.  All companies lending mortgage money must follow the Truth in Lending Act: mortgage brokers, non-depository lenders, and depository banks.  Obtain a GFE from a mortgage broker, a bank, and a non-depository lender (sometimes they like to refer to themselves as “mortgage bankers” but mortgage lenders is a better description, IMO.)

Consumer’s: slow down and take the time to meet your loan originators in person. An initial F2F meeting will help you gather valuable data as to how your loan process is going to go.  Remember, an institution or a loan originator offering the lowest rate, lowest APR or lowest payment does not always mean this is the best choice.  If it sounds to good to be true, IT IS. Trust your instincts and your rational mind.


27 thoughts on “APR: Just One Part of the Mortgage Machine

  1. Jillayne,

    Thanks for your interesting article. I am quite surprised to learn that APR calculations can vary and/or be manipulated to the extent you describe. Even though this is probably common knowledge to those in the lending industry, I doubt most consumers know about it.

    Taking into account the variables you described in calculating the APR, how much APR spread might actually exist (ie, worst case) for two loans with a seemingly identical APR?

    Too bad mortgage brokers don’t add value for their customers by providing the additional transparency needed to do a proper apples to apples “corrected” APR comparison between lenders. The sad truth is they have no financial incentive to do so.

    Thanks again for your insights. You are a breath of fresh air in an increasingly ethically polluted world.


  2. And be careful of application fees. A previous neighbor applied for a mortgage at the large national bank where she held her checking account. In her next bank statement she saw that $250 had been deducted as a mortgage application fee even though they denied her application. She was not told before hand that this fee would apply (although I suspect that it was in something that she signed).

    This is the story my neighbor told me. I have nothing but her word that it is true.

  3. I agree with Jeremy – Great Information and Educating! I too learned something new that APR was regional. I am surprised that the Feds do not require one method just for calculation reasons on a national basis. Learn something new every day! What I am wondering is, are charts used readily by customers. I can go into my favorite Mega-Mart and see how any prepaid phone minuets apply – ok maybe that’s a bad example based on recent press – but still as a customer have the ability to see what product may be best for me on a personal level. In my case what I save is equal to how many doughnuts I would be able to buy per week. Guess it’s the little things. Thanks for the information put down in an easy to understand and educational format. I will keep it in mind should I come across anyone needing a better understanding of your topic.

  4. Bravo, Jillayne. I’m glad to see you tackle (pardon my Superbowl terms) APR. Can you imagine a consumer selecting a lender from APR believing they have the best rate when in fact, they may not?

    You know I also recommend that borrowers obtain 3 referrals from a friend, co-worker, CPA, CFP or real estate agent.

    I have more tips on picking a lender and questions you should ask the loan originator on this post: http://www.mortgageporter.com/reportingfromseattle/2007/01/how_to_pick_a_l.html

  5. Hi Jeremy,

    Manipulated is such a strong word. The best case scenario is that HUD allows for variations up to an eighth of a percentage on fixed rate loans and a quarter on adjustable rate products, IN EITHER DIRECTION. This means the gross tolerance is
    .25% on fixed and .50% on variables. That’s the best case. Again, this wouldn’t be considered as manipulation; the feds call that “fair.” I’ll say more about that in my response to Shane.

    Worst case scenario is that your lender is not quoting APR at all in solicitations for business, just the note rate, or, even worse, just the starting rate on an adjustable rate product with no mention that the rate quoted adjusts. For an example of this, look at the lowermybills.com banner ads.

    Since APR is terribly difficult to compute by hand, lenders use software to do this task, software that is hard coded to comply with Truth in Lending laws.

  6. Hi Shane,

    HUD decided that since different regions in the U.S. have different local customs and different services needed, that the best way to be fair is to allow for variances in what’s considered a “prepaid” HOWEVER, the lender must have a letter on file that they received legal counsel to that effect.

    You asked about a chart. Here in Rain City, we have a large newspaper that routinely publishes a list of lenders, with rates and fees. ONLY focusing in on APR on chart comparisons generally would not lead the consumer to a good outcome because APR is a moving machine part.

  7. She did not pursue a refund actually. The person at the bank who did the application was a friend of hers and she did not feel comfortable pushing it.

    Which suggests that perhaps she should not mix social and business relationships.

    I certainly would have pursued it.

  8. Rhonda,

    I pulled this little piece out of Shane’s comment “as a customer have the ability to see what product may be best for me on a personal level”.

    My perception from my side of the fence is that the consumer needs to first know their credit score. If their credit score is 720 or higher or even 660 or higher, and they have 20% down, the charts work. But most people do not fall in that category.

    Once they are doing less than 20% down and have credit scores that don’t match the chart “assumption”, they proceed in looking at houses without knowing that the chart rate “isn’t for them”.

    I think Shane is looking for a true comparison picture of loan rates and costs, but isn’t it so credit score and amount of downpayment dependent?

    Do the charts ever have a disclaimer like “if your credit score is at least X these rates apply”?

  9. Absolutely, Ardell. Credit score and funds available for down payment and closing costs are crucial. I would never recommend that someone try to determine a loan product or strategy by a chart. To use Jillayne’s analogy comparing loan originators to Doctors in her comments from http://www.raincityguide.com/2007/02/02/children-can-you-say-suitability/ , this would be like a patient trying to read a doctor’s chart.

    Mortgages are far more complicated than the days of needing 20% down for conventional or FHA or VA for your minimum down products.

    Beyond credit scores and down payment, the main factor for rate is whether or not can go “full doc

  10. Rhonda,

    Yes, kind of in the best way I can think of to answer your question, but after reading the other post I can understand the complexity of what I guess you could think of as match making the loan with customer. If I understand it right a chart would not work as well as a more complex computer program based on all the variables involved. The same is true in my industry. Thank you for helping me understand better 🙂

  11. Shane, it really takes a consultation with a qualifed mortgage planner to help determine what the best program would be. And, this should be free–there should not be an application fee EVER as someone was charged by their bank (comment 2). A credit report may cost $18 for a tri-merge (all 3 bureaus) from a lender at most.

  12. Hey Shane,
    Glad you liked it.
    Sometimes it helps to be able to visualize.

    In my motor engine analogy, what’s missing, besides the rest of the car, is the DRIVER. We wouldn’t want to put a teenager behind the wheels of a racecar, but for a trained race car driver, this is not a problem.

    The loan originator acts like a coach, and a mechanic, helping fit the driver with the car and engine that will help the driver get from place to place along life’s highway without the driver doing harm to himself/herself and others.

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