Annual Percentage Rates (APRs) and Bad Credit Mortgages

By Gina Pogol
Mortgage Credit Problems Columnist

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The federal Truth in Lending Act requires that lenders express the cost of financing as an annual percentage rate. In theory, this should make it easy for consumers to compare loans with different fees to see which lender is offering the best deal. While an APR can be useful in comparing identical loans with different fees, there are some flaws in its calculation, especially for borrowers with bad credit.

Life of Loan:

The first flaw is that the calculation is done assuming that the borrower will keep the loan for the entire term, usually 15 or 30 years. If you spread the upfront costs over 2 years (which is as long as you should ever plan to keep a bad credit mortgage), the APR will be a lot higher. If you take an 8% start rate, pay $5,000 up front and refinance or sell the home after 2 years, your APR actually jumps to about 11% because the upfront costs are only spread over 2 years! A loan at 10% with no upfront charges would be a better deal as long as you can get out of the loan in 2 years.

Predicting the Future:

Consider also that many homeowners take out loans like 2/28 hybrid ARMs knowing that they won't be in the loan more than 2 years. However, the APR calculation is based on the assumption that once the first 2 years are up, the rate adjusts upward (some bad credit ARM rates are pretty steep) and remains high for 28 more years. Of course, no one can tell where market rates will be when the rate adjusts. For loan shoppers, an APR disclosure today may not even match that of the same loan tomorrow--it depends on what rates are when the APR is calculated.

Costs Vary between Mortgage Lenders:

While the government says that lenders have to include lending fees in the calculation, it doesn't specify what those fees are. Some lenders include title charges, appraisals, etc. and others don't.

How to Shop for a Loan:

Disclosures can be useful if you keep the following in mind:
  1. Use the APR calculation only to compare the same kind of mortgages. An APR comparison between that of an ARM and a 30 year fixed mortgage, for example, is of little value.
  2. Keep your timeline in mind. If you don't expect to keep the loan forever (you have 2 years to improve your credit--use them!) look more closely at the fees on the Good Faith Estimate (GFE). Get the best start rate with the lowest fees--and make sure that if there is a prepayment penalty it doesn't exceed 2 years.
  3. Expect small differences in APRs between lenders that may be due to the calculation, not the actual rate and fees. When choosing between loans, a slight difference in APR may be meaningless. Select the lender you feel most comfortable with.

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