The Consumer Financial Protection Bureau (CFPB) has developed two new disclosure forms designed to make the mortgage process more manageable for borrowers. The first two articles in this series showed that the new disclosures will not protect borrowers from unjustified price changes while the loan is in process, nor will it help borrowers shop for the best price. This article considers whether the disclosures will help borrowers select the type of mortgage that best meets their needs.
The new loan estimate form retains the Annual Percentage Rate (APR) disclosure from Truth in Lending, which makes sense. The APR is a good measure of the cost of the loan to the borrower over the period the borrower has it. The problem with the APR has always been that it is calculated over the full term of the mortgage, though very few borrowers have their mortgage for the full term. Here is an example of how the full-term APR can lead borrowers with shorter time horizons astray.
On December 27, 2013 a borrower with strong credit credentials shopping my site for a $200,000 loan was quoted 4.375 percent on a zero-fee, 30-year fixed-rate loan, and also 3.375 percent with upfront fees of $19,000. Which is better? The APR on the first loan is 4.375 percent and on the second it is 4.19 percent, suggesting that the low-rate/high-fee loan is better.
However, if the APRs are calculated over five years rather than 30, the APRs are 4.375 percent and 5.67 percent. Compressing the fees into a shorter period raises the APR on the high-fee loan. The borrower in this case has to expect to be in the house for more than 14 years to make the low-rate/high-fee loan the better choice.
There are two possible remedies for this problem. The best is to ask borrowers to provide a best guess as to how long they will have the mortgage, and calculate the APR over that period. An alternative is to calculate the APR over several periods. While borrowers would have to do their own interpolations, this would be far better than encouraging them to believe that the APR calculated over the full term applied to them.
The CFPB has done neither. Only one APR is shown on the loan estimate, and it is the same full-term APR that is on the TIL.
The APR on adjustable rate mortgages (ARMs) has another problem. An APR calculation requires an interest rate for every month the loan is in force. On ARMs the rate is known only for the initial rate period. The rate that kicks in after that is based on the value of the interest rate index at that time, which is not known at the outset.
The assumption used in the APR calculation for ARMs is that the interest rate index remains unchanged through the life of the loan -- a "no-change scenario." A 5/1 ARM that was available on December 27 at 3.25 percent with zero fees had an APR of 2.98 percent, the result of assuming that the index rate of 0.584 percent at that time remained unchanged for 30 years.
Of course, no assumption about interest rates over the next 30 years is going to be right. To be useful to borrowers, the APR on ARMs should be disclosed using alternative scenarios that are likely to bracket the possible outcomes. A no-change scenario could be usefully combined with a worst-case scenario, where it is assumed that the rate on the ARM increases by the maximum amounts allowed by contractual rate adjustment caps and maximum rates.
Consider a borrower trying to decide between the 30-year FRM at 4.375 percent and zero fees, and a 5/1 ARM available at the same time at 3.25 percent and zero fees. The APR on the FRM is 4.375 percent regardless of future rates. The ARM has an APR of 2.98 percent on a no-change scenario, and 6.13 percent on a worst case scenario, which is not very helpful. But that is because the ARM APRs are calculated over 30 years. Here are some other worst-case APRs on the ARM.
Five Years: 3.25 percent
Eight Years: 4.39 percent
12 Years: 5.38 percent
30 Years: 6.13 percent
Note that at eight years, the worst case APR is very close to the APR on the FRM. This means that a borrower who expects to be out of the house within eight years will do better with the ARM. That is useful information.
The upshot is that the APR would be useful to borrowers in making mortgage selections if it were calculated for multiple periods, and if on ARMs it was calculated on both no-change and worst-case scenarios.
Instead, CFPB has decided to leave the APR as it is, and to add three additional measures: total interest paid over the loan term, total payments of all types over five years, and total principal payments over five years. These measures seem to have been selected because borrowers understood them, but that does not make them helpful in choosing between different mortgage types. For that purpose they are largely useless.