Hot out of the broker oven mailbox today is this question:
I am in the process of refinancing. Can you please tell me what the APR should be for a $295,800 loan? The broker is charging 2% origination fee and 1.5 loan discount. The interest rate at 6.64. I’m not sure if it makes a difference but its a adjustable rate and balloon loan. After 2 years mortgage will go up.
The total settlement charges are $14,590.77. The truth-in-lending disclosure has an annual percentage rate of 10.634%. This doesn’t look right.
I questioned the broker and he said that rate is all the fees and payments that are in the loan. This is not my first time refinancing and I never saw it that high. Why is the difference so much?
Disclaimer: I am not privy to the reasons or motivations for this transaction; nor the particulars above and beyond the above question. Below are simply some general thoughts that stand out from the above inquiry. I could be completely off-base in any one of my assumptions.
I had to step away from the computer and take a lap before responding to this mailbag question. Before we get to the APR/rate discussion there is another point I want to highlight first:
(1) Paying discount points to achieve a lower rate when taking a short-term ARM is always a money-losing proposition. Because this is a short-term 2-year ARM loan you will never recoup the money you paid in points to get the lower interest rate (1.5 points or $4,437 in this instance). In order to simply break even on the money spent for the loan discount in the two years before your rate adjusts your monthly mortgage payment would need to be $185 less than it would be otherwise with out the discount points.
If we make a rough assumption that each point paid in discount reduces your interest rate by .5% (a reasonable assumption on a subprime 2-year ARM, might be a bit generous) then your interest rate with out paying the 1.5 loan discount points should be around 7.39. This makes your mortgage payment $150 more per month than at 6.64. By paying the discount points you are effectively throwing away $837 of your equity.
And that is just on the discount points – if we take the entire cost of the refinance – the $14,000+ you would need to save $608 per month to recoup the costs of this transaction.
If you need a lower mortgage payment for a short period of time there are better options; but for the sake of brevity I’ll let others comment instead.
For more on this matter you can read my post entitled “Why shopping for the lowest interest rate can cost you thousands.”
(2) The loan discount and origination fee are a total of $10,353 leaving an extra $4,200 in closing costs that are in the loan. Depending on the title insurance policy fees, other costs, your state of residence, etc. this is feasible. With $14,590.77 in closing costs the APR will be above 10%. That is because APR takes in to consideration the total cost of the loan including the money spent to get the loan. The $14,590.77 is money that is lost from the equity of your home for doing this transaction.
Bottom line, the APR calculation they provided you looks correct. The amount of fees you are paying for this transaction are accounted for in your APR and it is the $14,590.77 in fees for this loan make the APR so high. You are right to question the difference between your interest rate and your APR. I would recommend exploring all of your options when it comes to this transaction to find a program that makes the best use of your home’s equity while meeting the needs of your financial situation.
Any one else?
Robert Kerr says:
10.6% APR, on an $300K ARM?! $15K in settlement costs?! Ouch.
That’s a train wreck in slow motion.
June 14, 2007 — 7:26 am
Sean says:
The APR calculation looks, however, the APR on ARM loans does take into account potential future adjustments. Not sure of the exact formula, but most likely worst case, lets say 3%. If you calculate the APR on the above scenario (all costs the same) using a 30 year fixed loan, the APR is only 7.112%.
June 14, 2007 — 7:48 am
Morgan Brown says:
I reverse engineered the APR using a 2-year ARM based on the LIBOR Index at ~5.3 and a margin of approximately 5%. I used a cap structure for the loan of 5-2-5 and then plugged in the fees. I was able to pretty accurately recreate the above APR using those figures.
June 14, 2007 — 8:22 am
Sean says:
Meaning it does take into account the future cap adjustments?
June 14, 2007 — 8:28 am
Morgan Brown says:
Hi Sean – the APR for a subprime ARM (if this is indeed one – it seems like it is) is calculated by the index of the loan plus the margin, plus the fees. I was just explaining the example that I chose should anyone come along and wonder how I re-created the APR. I chose what I considered a fairly standard subprime ARM setup.
June 14, 2007 — 8:40 am
JeffX says:
APR calculations are ambiguous at best and purposely deceptive at their worst.
There is no standard method to determining an APR only ‘suggested formats’, thus they can vary from lender to lender even using the exact same numbers on the exact same loan scenario. Too many variables, waaay to many variables.
The reason no one can explain exactly how APR is determined is because most mortgage professionals don’t have a Masters in mathematics. For those who would like a crack at it (no calculators allowed):
LA – F = P1/(1 + i) + P2/(1 + i)2 +… (Pn + Bn)/(1 + i)n
i = IRR
LA = Loan Amount
F = All other fees
P = Monthly payment
n = Month when the balance is paid in full
Bn = Balance in month n
F–HERE IS WHERE THE SUBJECTIVITY AND DEVIATIONS BEGIN and the validity of the APR as a measurement of true loan cost goes out the window.
n–Show me a borrower who knows what month the balance will be paid in full and i’ll show you my dead grandparents.
Ignore the APR as well as other magical integers, percentages, ratios, etc that pundits claim to be THE way to shop for a mortgage.
Look at the effective interest rate, add every single line item fee, regardless of what they’re called, to come up with one aggregate dollar figure.
Compare the interest rate plus the aggregate fee total from lender to lender….WARNING…what you are quoted on a GFE and what ultimately appears on the HUD-1 at the closing table are likely to cause high blood pressure.
DEMAND your broker/banker/lender send you AT MINIMUM 3 GFE’s…one during the initial quote, one after the loan package has been approved by underwriting, and one 72 hours prior to close.
Keep your mortgage pundit on a choker collar and a short leash and you just may get what you bargained for.
June 14, 2007 — 12:39 pm
Brian Brady says:
Hey Fellas!
The question was why is my APR different from my rate not whether APR is a valid assessment of the cost of the loan.
Morgan did an admirable job addressing a question with incomplete information and Mr. Kerr’s critical comment seems to be accurate.
June 14, 2007 — 1:11 pm
Sean says:
It appears that was the title of the post, the borrower states that they have refi’d before and have not seen such a disparty in the rate and APR, whis what led to my initial comment
June 14, 2007 — 3:08 pm
JeffX says:
I’m guessing you were directing your comment to me Mr. Brady 😉 You missed another calling in life…Mediator. (I do mean that in the nicest of ways)
Simply trying to nip the question in the bud by explaining “How” APR works before the explanatory metamorphosis towards “Why” it ended up where it did.
I too applaud Morgan for his more than admirable job of addressing the question head on, especially since he was left to fill in some blanks.
Cheers!
June 14, 2007 — 3:34 pm
Brian Brady says:
Mediator? I guess we all grow up, huh X?
Rhonda did a great job at RCG awhile back explaining why APR is completely useless. You’re formula shows why it’s unreliable at best
June 14, 2007 — 6:05 pm