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
APR
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.