APR Can Be Deceiving

A borrower who is shopping for the best mortgage rate can easily be seduced by low rate offers that are accompanied by low Annual Percentage Rates (APR). Federal Law requires that APR be disclosed along side the actual interest rate…this is in order to help borrowers make a more informed decision on their mortgage. The truth is that APR is a very poor way to comparison shop for a mortgage and can cause borrowers to make costly wrong decisions.

APR was created in order to provide a way for borrowers to account for costs associated with the mortgage. This sounds good because it may not be very easy to choose between a loan with a lower rate and higher fees or a loan at a higher rate and low fees. The problem is that the APR calculation makes some very bad assumptions. First, APR assumes zero inflation and that the value or buying power of a Dollar today will be exactly equal to the value of a Dollar 10, 20 even 30 years from now. Next, the APR calculation assumes that the mortgage will never be prepaid or paid off. That means no refinancing or selling the home…highly unlikely since the average life of a home mortgage loan is less than four years. Just think, about your own clients. Is it not rare to see the same loan in place for even 5-years…forget 30-years. The APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it were not spent on closing costs. Finally, APR does not take tax consequences into consideration. This can be significant since higher fees on the mortgage may not be deductible while the higher interest rate typically is deductible. Moreover, APR can be manipulated, making it totally worthless.

So how does APR work anyway? I like to explain it to my clients by using triangles. I often draw two sets of triangle for my clients to illustrate the difference between Interest Rate and APR. The reason for the triangle is because there are 3 sources of input…"Interest Rate", "Mortgage Amount" and "Monthly Payment". If you know any two of the three, you can calculate the third. See the triangle below.



Since any two of the three variables allows you to calculate the third, a $911 monthly payment for a $150,000 mortgage calculates to an interest rate of 6.125%. But the APR calculation uses different information. The APR calculation only keeps the "Monthly Payment" information the same. Instead of the "Mortgage Amount", APR uses "Amount Financed". This is the "Amount Financed" information on the Truth in Lending statement. Amount Financed takes into consideration the fees that are lender imposed. This includes application fees, points, commitment fees…and interim or per diem interest. So, Amount Financed is the mortgage amount less any lender fees, points and interim interest. The more fees, the lower the Amount Financed. The monthly payment is then calculated as a product of the Amount Financed to give you the "Annual Percentage Rate" or "APR". So the lower the "Amount Financed", the higher the "APR" is. Amount Financed can be manipulated by assuming a closing on the last day instead of the first day of the month. That would increase the Amount Financed and decrease the APR.



Here is a real example on a $150,000 fixed rate 30-year mortgage with zero points: Lender "A" (triangle above) is offering a great low rate of 5.875% and lender "B" (triangle below) is offering a higher rate of 6.125%.



A closer look shows that Lender "A" is charging $3,000 more in fees than Lender "B". How do you compare? If you look at APR, Lender "A" (5.875% with $3,000 higher fees) has an APR of 6.149%. Lender "B" (6.125% but a $3,000 savings in fees) has an APR of 6.211%. So according the APR, Lender A is a better deal even though the fees are $3,000 higher…this is exactly what these high fee lenders are hoping you look at.

Let's look at the real story. The payment difference between the two is $24 per month. So is it worth paying $3,000 in fees to Lender A in order to save $24 per month? Hardly. It will take 10.5 years for a borrower to just to get back their investment! A bad choice when you consider that mortgage loans typically are retired within four years. To make the decision to go with Lender "A" even worse, if that's possible, borrowers rarely take the value of today's dollars into account. Rather than giving Lender "A" the windfall of your hard earned $3,000, you should give it to yourself. Reduce the loan balance on your mortgage by the fees you are saving. In the example above that would reduce the loan from $150,000 to $147,000. This makes the payment difference just $6 per month instead of $24 per month! The true time to break even is really 500 months (more than 40-years!). So it is impossible to benefit from the higher fee program from Lender "A" because the maximum period on the loan is 30 years or 360 months. One more thing…when you calculate your tax deduction on the payment difference, it makes even more sense to avoid paying higher non deductible fees. The obvious correct choice is to go with Lender "B" even though the APR is lower with Lender "A".

Market Update June 22, 2007

Current Price of FNMA 6.0% Bond: $98.38, -3bp

Mortgage Bonds are trading slightly lower and have improved from the worst levels of the day as prices approached the nearest support level, located at $98.28. There are no economic reports today to influence pricing, so Mortgage Bonds will likely trade between support and resistance.

Next week is going to be very exciting with a full plate of high-impact economic reports. Existing Home Sales is scheduled to be released on Monday. New Home Sales and the latest read on Consumer Confidence are set for release on Tuesday. Wednesday brings Durable Goods Orders, but the real action begins Thursday with the Fed’s Monetary Policy Statement and interest rate decision. There is no chance of a Fed rate change next week, but it will be very interesting to hear the Fed's take on core consumer inflation, which appears to be moderating as forecasted.

Speaking of inflation, next Friday the week gets capped off with a potential market blockbuster, the Core Personal Consumption Expenditure Price Index (PCE) – the Fed’s favorite gauge of consumer inflation. At the moment, economists are forecasting the year over year Core PCE to be reported at 1.9%, which would show further moderation of core consumer inflation. This would be good news for Bonds.

After peaking on Tuesday, prices continued to drift lower under the Falling Resistance Line until touching down exactly on the floor of support at $98.28 this morning. Let's see if Bonds can bounce a bit higher from here. Should prices break below the current floor, there is real strong support at the $97.84 level

Market Update June 21, 2007

Current Price of FNMA 6.0% Bond: $98.59, Unchanged

With the extremely high level of volatility we've seen lately, it sure is clear how important it is to stay dialed in to what the market is doing and why. In just the past 24 hours, we have seen the Bond shift from positive momentum to negative momentum rather quickly. In fact, just this morning we have seen prices move from up 6bp on the day, to down 12bp, back higher to be unchanged on the day in just one trading hour - now that's volatility!

So as we ride through the volatility, it's important to understand all the factors causing the change - and with a light news week continuing, technicals continue to play a huge role. In yesterday's update we discussed the Falling Resistance Line, and how the overall trend for Bond pricing remains lower. Seeing Bond prices fall back after approaching resistance yesterday was not a good technical sign, and could lead to a continued move lower.

Here's another very interesting factor playing into the current weakness of Bonds - Corporate Bond Issues. What the heck does a company selling their own Corporate Bonds have to do with Mortgage Bonds? Here's the story. Companies will from time to time issue debt against their company, as a way to raise capital without giving away stock ownership. But as they prepare to do so, they see that if rates are continuing to move higher, the price they will get for their Corporate Bonds will be lower. So just before they issue their Corporate Bonds, they "hedge" against upward swings in interest rates by shorting other Bonds, like Treasuries. This protects the companies from a sudden move higher in rates, as if rates were to move higher, the companies would likely have to pay more interest on their new corporate issues to meet current market conditions...but at the same time make money on the selling of the Treasuries - thereby "hedging" their actions.

This shorting or selling of Treasury Bonds temporarily drives prices lower in the entire Bond market - including Mortgage Bonds. But when the Corporate Bonds are actually priced and issued, this "hedge" trading is reversed, with the Treasuries being bought back, providing a subsequent boost to the Bond market in the other direction. These hedging activities can create abrupt volatility in the Bond market and this was likely a contributor to the volatility both yesterday and so far today.

For now, the Bond looks poised to move lower and test a floor of support at the $98.28 level, about 30bp lower than present levels. With no high-impact reports due until next week and the technicals turning negative, a bias towards Locking appears prudent at this time.

Market Update June 20, 2007

Current Price of FNMA 6.0% Bond: $98.81, -19bp

"If you don't know where you're going, chances are you will end up somewhere else" - Yogi Berra. And Mortgage Bonds look like they don't know which direction to go so far this morning. After a healthy Bond rally which started last Wednesday, Traders appear to be taking some profits, pushing prices lower this morning.

And with no scheduled economic news to help provide market direction, pricing will be driven by technical factors. One look at the Bond Page shows some formidable ceilings of resistance, which will make it more difficult for this rally to continue. Notice the Falling Resistance Trendline, which is why the trend direction remains lower, even after the recent rally. Additionally, the 25-day Moving Average, as well as the Falling Window discussed yesterday, are both very tough barriers.

With pricing improving 125bp in the past week, we don't want to give up any of those gains, but at the same time we want to wait and see if the Bond can reverse higher today - just like it has three of the past six days. For the moment, we are advising Floating because most of this morning's losses occurred before rate sheets came out, and so far has only resulted in a partial giveback of yesterday's rally.

Market Update June 19, 2007

Current Price of FNMA 6.0% Bond: $98.84, +9bp

Mortgage Bonds are trading higher thanks in part to a Housing Starts and Permits Report which met economist's expectations. Overall, the Report for May showed that while new housing demand is slower, the market is stabilizing.

Since this will be a slow economic news week, the technicals will play a more prominent role - and from that standpoint, Mortgage Bonds are presently looking pretty good. Take a look at the Bond Page, and you can clearly see that after testing the long-term support we identified at the $97.84 level last Wednesday, prices have now muscled their way over 100bp higher. Bonds also benefited from a Positive Stochastic Crossover, which indicates that Bonds had become "oversold", and were due for a move higher.

At the moment, the next clear ceiling of resistance is located at the “Falling Window” created on June 6 -7.

Market Update - June 18, 2007

Current Price of FNMA 6.0% Bond: $98.59, -9bp

Mortgage Bonds are trading slightly lower, but off of the best levels of the day.

At 1:00pm ET, the National Association of Home Builders will release the Housing Market Index for June. The report measures housing market conditions by surveying buyer traffic through model homes, expectations for sales during the next six months, and builders’ sentiment on current sales. Lately, builder sentiment has trended lower and weakened with readings of 36 in March, 33 in April, and 30 in May. A reading below 50 indicates more builders view conditions as poor rather than good. Should this report come in a little weak, Mortgage Bonds may benefit. Tomorrow, a further view on the health of the Housing Sector takes place with the release of the Housing Starts and Building Permits report for May.

After bouncing 100 basis points higher since last Wednesday, Mortgage Bonds appear to be taking a breather. We want to be patient and see if Mortgage Bonds can shrug off the early morning losses, but if prices are unable to recover you might be hearing from us later today as we are seeing the early makings of a Bearish Dark Cloud Cover Pattern.