Lew Sichelman, United Feature Syndicate
November 18, 2007
The worst method -- and the laziest -- is to go by the annual percentage rate, or APR, the calculation lenders are required by law to provide borrowers within three days after applying for a loan. You'll also see it in advertisements.
The APR is the total charge for credit on an annual basis stated as a percentage. It includes not only the interest rate but also one-time closing charges, such as points, that increase the overall cost of your loan. (A point is 1 percent of the loan amount.)
While it is smarter to base a borrowing decision on total cost than the contract rate alone, the APR calculation leaves a lot to be desired.
For one thing, finding out the APR after you apply (rather than before) doesn't leave a lot of room for comparison. But beyond that, the APR assumes you will keep the loan for the full term, say, 15 or 30 years, when most people sell or refinance within six to 12 years.
Because the effective interest rate of your mortgage depends on how long you keep the loan, the APR doesn't reflect your true costs. And the sooner you pay off your mortgage, the higher the APR.
Why? Because the cost of points is spread over a shorter period.
Take a 30-year, $200,000 mortgage at 7 percent interest plus 2 points. If you hold it for the full term, the APR would be 7.2 percent. But if you sold the house after six years and paid off the loan, the effective interest rate would be 7.33 percent.
But theorizing that the loan won't be paid early isn't the only "bad" assumption with the APR calculation, says Barry Habib of the Mortgage Market Guide, a Holmdel, N.J.-based service that helps loan originators improve their production. It also:
*Fails to account for inflation. The formula does not consider what the value of the dollar will be in five or 10 years, says Habib.
*Does not consider the value of the money for fees and other loan charges if they weren't spent on those costs.
*Neglects the tax consequences. "This can be significant," the sales trainer says, "because higher fees on the mortgage may not be deductible, while the interest paid on a higher rate usually is."
"If you were on an island and had only one choice, I'd say, 'Yes, go ahead and use it.'" says David Ginsburg of Loantech, a Gaithersburg, Md., mortgage audit software company. "But otherwise, it's like stabbing in the dark. I've seen plenty of cases where the loan with the lower APR costs more money, so I'd rather throw a dart at a dartboard."
The better way to compare loan costs is to calculate the effective interest rates, or EIR, of your choices. You'll need a financial calculator to come up with precise numbers, but you can use this formula from "The Mortgage Kit" by Thomas Steinmetz, a step-by-step workbook on how to determine the best deal:
For example, EIR equals the quoted rate plus the number of points divided by the number of years you expect to keep the loan.
So, looking at the $200,000 loan over six years, a 30-year mortgage at 7 percent and 2 points runs 7.33 percent and another at 7.25 percent and 1 point is 7.42 percent.
But the absolute best way to compare loans is to calculate their after-tax cost, or ATC, in dollars.
"The ATC is the best measure because it takes into account not only the interest rate, points and number of years you will stay with the loan but also your tax deductions," says Ginsburg of Loantech.
But there is no easy formula to determine the ATC. In fact, Ginsburg says it would take the average borrower "a couple of hours" of pushing buttons on a financial calculator to determine just one scenario. "You'd have to be a masochist" to go through all that, he says.
Which is why Loantech has developed a computerized service that contains the ATC for more than 500 possible rate-and-point combinations. The cost of the five-page report based on your loan amount and term and marginal tax bracket is $39.
But Ginsburg says "you can save more than $2,000 by picking the best combination of rates and points."
To determine your ATC, you'll need to figure out your monthly payments for principal and interest. Your lender or sales agent can help.
Next, multiply that times 12 to calculate your annual payment. Then determine your total payment by multiplying the result by the number of years you expect to remain in the house.
Then tally how much of that amount is interest. Again, your lender or agent can help. Next, add the points and you have your total interest expense.
Divide that by your tax bracket and subtract the result from your total interest expense. The final figure your be very close to the after-tax cost of that loan.
A lot of work?
Yes -- but worth it. And if you don't want to do it yourself, visithttp://www.loantech.com .
Write to Lew Sichelman c/o Chicago Tribune, Real Estate, 435 N. Michigan Ave., 4th floor, Chicago IL 60611. Or e-mail him email@example.com. Sorry, he cannot make personal replies. Answers will be supplied only through the newspaper.