Truth-in-Lending & APR

You may have heard the terms “APR” and “Truth-in-Lending,” but what exactly do these concepts mean? And how does this information apply to you as a consumer and borrower?

The Truth-in-Lending Act

The Truth-in-Lending Act (TILA) is one of the most critically important consumer protection acts in the mortgage business.  In order to protect consumers, it requires complete disclosure of all credit terms, the consumer costs of obtaining credit, and the rules that will protect consumers when they borrow using a home as collateral.

Truth-in-Lending regulation has a noble purpose.  It is designed to allow the borrower to comparison shop loan programs and the overall cost of credit while providing protection from inaccurate and unfair advertising.  Unlike the “Good Faith Estimate” which discloses the entire transaction’s cost, Truth-in-Lending deals only with the cost of the loan. TILA was created for the following purposes:

 

  • To protect consumers by requiring the disclosure of all costs and terms of credit
  • To create uniform standards for stating the cost of credit, thereby encouraging consumers to compare the costs of loans offered by different creditors
  • To ensure that advertising for credit is truthful and not misleading

 

The Truth-In-Lending Disclosure Statement (TIL) should be given to the consumer at the time of application.  If it is not, the lender has three business days from the date of application to mail the disclosure to the borrower.

The Annual Percentage Rate (APR)

One of the most important figures disclosed on the TIL is the APR.  The APR calculation may confuse the lenders and buyers alike.  “Annual percentage rate” sounds a lot like “interest rate” to most borrowers.  The APR is not an interest rate, but a theoretical measure of the cost of credit expressed as a percentage rate. The purpose of the APR is to provide consumers with a uniform measure of the cost of a loan.  The APR equation includes the contract interest rate and adds the costs of the loan, including any prepaid costs (points, fees, etc.) that are part of the cost of borrowing.  Ideally, borrowers can compare costs from company to company by comparing the APR.

 

The APR Formula: (Click Here For Chart)

1)  Compute total of payment by multiplying payment schedule, including PMI by amount of payments.

2)  Amount Financed is the loan amount, less points, prepaid interest, PMI, and lender fees

3)  Finance Charge is the Total of Payments less the Amount Financed

4)  Compute the APR by dividing the Total of Payments by the number of payments and apply that against the Amount Financed, as if it were the loan amount

The first step in determining an APR is to subtract the prepaid finance charges from the loan amount.  The result is the “amount financed.”  Next, the full principal and interest payment (including Private Mortgage Insurance or PMI ) is applied against the “amount financed” as if it were the loan amount.  The resulting interest rate is the APR.

What are Finance Charges?

A prepaid finance charge is any charge one must pay in exchange for obtaining a loan (charges you would not incur if you were paying cash for the property).  Like the APR, it can be used by consumers as appoint of comparison between lenders.  Finance charges include loan fees (discount points, origination few, PMI) and miscellaneous fees (tax service, underwriting, document preparation, or lender review few).

In addition, some prepaid items such as per diem interest and escrows for PMI or prepaid PMI, FHA upfront MIP (Mortgage Insurance Premium), and the VA (Veteran’s Administration) funding fee are considered finance charges.  Other prepaid items, such as association dues, are not included.

Appraisal and credit report fees are not included when they are collected as part of an application fee.  Any inspections (termite, well, septic, etc.) that are required by lenders are not considered finance charges.  Fees for recording a deed of trust are not included either.  The only exception is a construction loan draw inspection.

Third Party Fees

There are a number of third party fees involved with the finance charge; Regulation Z (12 CFR 226.4(b).) lists the following charges from third parties as examples of fees that the creditor must include when calculating the finance charge:

 

  • Interest, time-price differential, and any amount payable under an add-on or discount system of additional charge
  • Service, transaction, activity, and carrying charges
  • Points, loan fees, assumption fees, finder’s fees, and similar charges
  • Investigation and credit report fees
  • Premiums on insurance protecting the creditor against the consumer’s default
  • Charges imposed on a creditor by another person for purchasing or accepting a consumer’s obligation
  • Premiums or other charges for credit life, accident, health, or loss-of-income insurance, written in connection with a credit transaction
  • Premiums for homeowner and liability insurance written in connection with a credit transaction
  • Discounts to induce payment by a means other than the use of credit
  • Debt cancellation fees

Excluded Fees From Finance Charges

There are also a number of fees that are excluded from the finance charge:

 

  • Application fees charged to all applicants for credit
  • Charges for unanticipated late payments, exceeding a credit limit, or delinquency
  • Charges imposed by a financial institution for paying items that overdraw an account
  • Fees charged for participation in a credit plan, whether assessed on an annual or other periodic basis
  • Seller’s points
  • Interest forfeited as a result of an interest reduction required  by law on a time deposit used as security for an extension of credit
  • Real-estate related fees such as fees for title examination, charges for the preparation of loan documents, credit report fee, notary fees, appraisal fees, and amounts paid into escrow, if these fees are bona fide and reasonable
  • Discounts offered to induce payment by cash, check, or other means

Conclusion

Insurance and debt cancellation coverage can also be excluded if the coverage is not required by the creditor, the premium for the initial term of insurance is disclosed, and the consumer signs or initials a written request for the insurance.  If itemized and disclosed, certain taxes and fees prescribed by law are also excluded from the finance charge.

Explaining the amount financed would be much simpler if each loan came with an “itemization of amount financed.”  The itemization would include a detailed list of the loan amount, the payment schedule, and each finance charge.

Another factor in calculating your APR is the payment schedule.  To determine the payment amount to apply against the amount financed, divide the total of payments by the number of payments and use this average amount.  On a fixed-rate loan, the payment schedule is quite simple-the monthly payment is the same through the life of the loan.  Variable payments (as in an ARM, Buydown, GEM, or GPM) may be more complicated on a payment schedule.  The APR or ARMs can change based upon future interest rate changes.  Buydowns, GPMs, and GEMs have fixed payment schedules, so the APR on these loans will not change.

After the APR, amount financed, and total of payments have all been calculated, what is the total finance charge?  The difference between the total of payments and the amount financed represents the cumulative total of all interest and prepaid finance charges accrued on the loan, or the total finance charge. Subtracting the amount financed from the total of payments reveals this number.

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