TRUTH IN LENDING'S LITTLE LIES
The National Association of Mortgage Brokers has been lobbying Congress for 10 years to update the regulations referred to as the “Truth In Lending” laws, or “Reg Z”. Our pleas have fallen on deaf ears as more powerful lobbies than ours (Banking, for instance) saw no benefit to them to adopt a format of loan disclosure that was more honest. Before throwing blame around for the “subprime meltdown”, let’s look closely at what 20 years of inaction on the part of your elected representatives contributed to this credit crunch.
The much vaunted “Truth In Lending” or “Reg Z” documentation is hopelessly outdated. The dictated formula for calculating every mortgage’s Annualized Percentage Rate (APR) hasn’t changed for over 30 years. In real life, where Congress fears to tread, mortgage products that adjust have become steadily more numerous than fixed rate/fixed payment products. The APR as calculated by the Federal Government is grossly inaccurate for those consumers buying adjustable rate mortgages, it has been inaccurate for years, but like I said, the banking industry has their reasons for keeping this misleading formula in place.
First, a summary of what the APR is supposed to do: The Note Rate (the percentage printed on the Promissory Note) is just the beginning of what a mortgage can cost. Let’s say that rate is 6.00% on a plain vanilla, 30 year fixed rate mortgage. So, the APR begins with 30 years at 6%. Next, it adds in the origination fees that everybody has to pay (usually about a thousand dollars). Next, it adds in any points (prepaid interest expressed as a percent of the original loan amount – usually one point is paid). Then it takes all those up-front expenses and adds those dollars to the interest dollars over 30 years and comes up with an Annualized Percentage Rate. And that works pretty well for fixed rate fixed term fixed payment loans. You can compare the real cost of borrowing using the APRs of competing loans, unless of course, the Note Rate is subject to the whims of global borrowing rates.
Now cross the chasm of understanding to Adjustable Rate Mortgages (ARM). Here the APR takes the origination costs, and adds them to the interest that will be paid over the life of the loan using the “fully indexed” rate through maturity. The “fully indexed” rate takes the Bank’s cost of borrowing (the Index) and adds their profit margin (the Margin) to come up with what you, the borrower must pay. The dirty little secret that the Federal Reserve (which administers Regulation Z) will not admit is that in its simplistic approach Reg Z assumes that the underlying index will not change. Avoiding prognostication is to leave the consumer unaware of dangers. Mandated automobile disclosures warn of impending death and the need for safety belts, but future rate increases (almost a certainty) are allowed to sneak up on unsuspecting borrowers. While the most popular indexes have been bottoming out in historical (all time) lows, the propaganda machine that convinced consumers to use the APR and only the APR to judge loan prices has chewed up the true cost of a loan and spit out the wrong impression. As LIBOR touched bottom at a little under 2%, adjustables based upon it looked lower than a fixed rate loan with no points. Even if the margin was a high 4% (typical margins are 2.25% to 2.75%), when added to a 2% LIBOR level, this unrealistically low “fully indexed” rate made the deal looked pretty darn good. The teaser start rate could be say, 5.5%, and the Reg Z would show our consumer that when it adjusted after two years, it would adjust to 4 + 2, or only 6%. The cruel reality is that LIBOR will probably never be that low again, and the caps, or lifetime possible highs on those loans were in the double digits, something the Truth in Lending document fails utterly to disclose. Customers who could have had a 6% fixed rate loan chose instead the “cheaper” adjustable rate loan, and now, when LIBOR is once again around 5%, they are wondering how they missed the boat.
What should you do? Tell your elected representatives to quit blaming the products and the sellers, and cast a shining light on their own failures to update consumer protections to reflect a more complex reality.
The much vaunted “Truth In Lending” or “Reg Z” documentation is hopelessly outdated. The dictated formula for calculating every mortgage’s Annualized Percentage Rate (APR) hasn’t changed for over 30 years. In real life, where Congress fears to tread, mortgage products that adjust have become steadily more numerous than fixed rate/fixed payment products. The APR as calculated by the Federal Government is grossly inaccurate for those consumers buying adjustable rate mortgages, it has been inaccurate for years, but like I said, the banking industry has their reasons for keeping this misleading formula in place.
First, a summary of what the APR is supposed to do: The Note Rate (the percentage printed on the Promissory Note) is just the beginning of what a mortgage can cost. Let’s say that rate is 6.00% on a plain vanilla, 30 year fixed rate mortgage. So, the APR begins with 30 years at 6%. Next, it adds in the origination fees that everybody has to pay (usually about a thousand dollars). Next, it adds in any points (prepaid interest expressed as a percent of the original loan amount – usually one point is paid). Then it takes all those up-front expenses and adds those dollars to the interest dollars over 30 years and comes up with an Annualized Percentage Rate. And that works pretty well for fixed rate fixed term fixed payment loans. You can compare the real cost of borrowing using the APRs of competing loans, unless of course, the Note Rate is subject to the whims of global borrowing rates.
Now cross the chasm of understanding to Adjustable Rate Mortgages (ARM). Here the APR takes the origination costs, and adds them to the interest that will be paid over the life of the loan using the “fully indexed” rate through maturity. The “fully indexed” rate takes the Bank’s cost of borrowing (the Index) and adds their profit margin (the Margin) to come up with what you, the borrower must pay. The dirty little secret that the Federal Reserve (which administers Regulation Z) will not admit is that in its simplistic approach Reg Z assumes that the underlying index will not change. Avoiding prognostication is to leave the consumer unaware of dangers. Mandated automobile disclosures warn of impending death and the need for safety belts, but future rate increases (almost a certainty) are allowed to sneak up on unsuspecting borrowers. While the most popular indexes have been bottoming out in historical (all time) lows, the propaganda machine that convinced consumers to use the APR and only the APR to judge loan prices has chewed up the true cost of a loan and spit out the wrong impression. As LIBOR touched bottom at a little under 2%, adjustables based upon it looked lower than a fixed rate loan with no points. Even if the margin was a high 4% (typical margins are 2.25% to 2.75%), when added to a 2% LIBOR level, this unrealistically low “fully indexed” rate made the deal looked pretty darn good. The teaser start rate could be say, 5.5%, and the Reg Z would show our consumer that when it adjusted after two years, it would adjust to 4 + 2, or only 6%. The cruel reality is that LIBOR will probably never be that low again, and the caps, or lifetime possible highs on those loans were in the double digits, something the Truth in Lending document fails utterly to disclose. Customers who could have had a 6% fixed rate loan chose instead the “cheaper” adjustable rate loan, and now, when LIBOR is once again around 5%, they are wondering how they missed the boat.
What should you do? Tell your elected representatives to quit blaming the products and the sellers, and cast a shining light on their own failures to update consumer protections to reflect a more complex reality.