Perhaps the most confusing form in our industry is the Truth-In-Lending Disclosure statement whose purpose is to allow mortgage applicants to compare loan products and offers. The key to the tool is the Annual Percentage Rate, or APR (discussed in more detail here). The confusion in the form lies in none of the numbers being familiar to the borrower based on discussions with the originator. The APR is usually higher than the rate quoted, the amount financed is less than the loan amount, and the finance charges being several hundred thousand dollars.
What is to follow is detailed in explaining how the Truth-In-Lending Disclosure works, what the numbers mean and how they are derived; while I have tried to simplify the explanations there it is not an easy form to simplify. At its most basic, the Annual Percentage Rate is meant to provide borrowers with the actual cost of their borrowing in the form of a percentage rate, how it is derived is not basic. So for a more complete understanding read on!
It is important to note that because of the fees and amounts used to calculate Annual Percentage Rate, Finance Charges, and Amount Financed, the Truth-In-Lending Disclosure Statement as a tool of comparison between loans and companies is useless without the Good Faith Estimate for the loan. Variables such as pro-rated interest, mortgage insurance, escrow fees and other third party charges greatly impact the final numbers, some originators can omit some third party fees or pro-rations to make their APR appear lower. Always make sure you get a Good Faith Estimate with your Truth-In-Lending Disclosure.
Let's dissect the form and the numbers for a clearer understanding of what they mean and where they come from:
This is what the Truth-In-Lending, also referred to as the TIL or Reg Z, for looks like at the top. For our purposes this is for a $500,000 purchase transaction with 20% down payment, a 30 year fixed rate loan at 5.00% at a cost of 1 point for $400,000.
(1) Section 1 Should contain the date prepared, the name and address of the originator or lender who is providing the TIL and the phone number of that company. On the left should be the name of the borrowers and the address of the property for the transaction, make sure these match because often these are copied from one file to the next, if the address and borrower information is incorrect other information can be as well.
(2) Our confusion begins. Annual Percentage Rate, or APR, as you can see is not 5.00%, which is the rate for the loan. Why is this? Because the APR does not use the loan amount for its calculations but rather the Amount Financed:
(3) Our confusion continues. Amount Financed as you can see is not $400,000 but is about $6600 less than the loan amount. That is because the Amount Financed equals the loan amount ($400,000) less fees and payments that are considered by HUD as part of the finance costs and part of the APR calculation. Fees included in the amount financed, and therefore APR, calculations include, but are not limited to, points, lender fees such as underwriting, process, tax service, mortgage insurance, escrow company fees, prepaid interest to end of closing month, Homeowners Association fees. All of these fees are added up and subtracted from the loan amount to reach the Amount Financed figure. Note that depending on when the loan closes in the month, and fees from third parties such as escrow companies the Amount Financed will vary and therefore so will APR. For listing of the fees included and excluded from APR calculation see chart below.
Back to Annual Percentage Rate now that we have the Amount Financed we can calculate the APR. For loan payments the calculation is the Loan Amount amortized for the loan period using the interest rate. In our example $400,000 amortized for 30 years at 5.00% has a payment of $2147.29 per month paying principal and interest; or another way to look at it, if you make 360 payments of $2147.29 per month on a $400,000 the interest rate is 5.00%. For APR the calculation is using the same payment, $2147.29 every month for 30 years to pay off an Amount Financed of $393,372.22 (loan amount less costs) to reach an APR of 5.141%. So the APR is higher than the interest rate because the Amount Financed is lower than the loan amount for the same monthly payment and term.
(4) "I'm paying $380,000 in finance charges?!?" Finance Charges as listed here is the total interest and charges paid over the life of the loan. It is calculated by taking the Total of Payments (5) (360 x $2147.29) subtracted from the Amount Financed. In this instance if you borrow $400,000 at 5% and make payments for 30 years you will pay almost two times the original amount borrowed over the 30 year period.
A note: the payments listed below the disclosure line lists 359 payments at $2147.29 and 1 payment at $2144.22 is to make the last payment pay the loan down to exactly zero when the 30 year term expires; over time the fully amortized payment collects an extra $3.07 in principal with the rounding.