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My APR is lower than my note rate --- can that be right?

Posted by Tom Erickson on Jul 30, 2014 1:30:00 PM

APR lower then rate | TILAThe Truth in Lending Act (TILA) and its implementing regulation, Regulation Z, require Lenders to disclose the Annual Percentage Rate (APR) on the Truth in Lending form.  The APR is defined as the cost of credit per year expressed as a percentage of the Loan.  It takes into consideration the closing fees that are defined as prepaid finance charges (i.e., Origination fees, discount points, underwriting fees, processing fees, etc.) and any Mortgage Insurance that is required to be paid throughout the life of the loan.  The reasoning behind the regulation was so that consumers could more easily compare loan offers between lenders to make a more economical choice.


Adjustable Rate Mortgages (ARM) has several assumptions that occur in the calculation of the APR.  The total interest cost on these loans is calculated based upon the fully indexed loan rate.  This means that the initial interest rate is used for the initial term, but the subsequent changes are based upon the current index plus the applicable margin and caps that may apply for the remaining term of the loan.  Therefore, the APR is stated based on today’s index and not the index in the future that will determine the actual interest on the loan.  An illustration of how to calculate the fully indexed rate is:


Scenario I (This would be a typical interest rate atmosphere)


Product:  5/1 ARM ($2,000 in prepaid costs)


Initial rate:  5.50%


Index: 1 Yr Libor @ 6.24% (current)


Caps:  2/2/6


Margin:  2.25%


In this scenario, the initial rate is good for the first 60 payments @ 5.50%. The rate then has its first rate adjustment, which is calculated by taking the current index, 6.24%, plus the margin, 2.25%, would be 8.49%(this is the fully indexed rate).  Since the initial cap on this loan is 2%, the rate for the next 12 payments is at 7.50% and this would adjust again at the next adjustment period to the fully indexed rate of 8.49% for the remaining 288 payments.  The APR on this loan would be 7.305%--note the APR is higher than the initial note rate.  This is a typical transaction.


Scenario II (This would be a very low interest rate environment)


Product:  5/1 ARM ($2,000 in prepaid costs)


Initial rate:  3.25%


Index:  1 Yr Libor @ .554% (current)


Caps:  2/2/6


Margin:  2.25%


In this low-rate scenario, the initial rate, 3.25% is in effect for the first 60 payments.  At the first rate adjustment the new payment is calculated by taking the current index of .554% plus the margin of 2.25% would be 2.804% (fully indexed rate).  Since this is within the caps allowed, this is the rate used to calculate the remaining 300 payments.  The APR on this loan would be 3.05%--note the APR is actually lower than the initial rate.  This is abnormal for a typical mortgage market but does happen, just like the market we have been in for the last few years. 


To find out how Marksman can get more accurate rates pushed instantly to thousands of potential borrowers, schedule a free, consultative demo today.


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