Why is the APR (annual percentage rate) of my 3, 5 or 7 yr ARM (adjustable rate mortgage) less than the start rate?

Good question. The concept of APR is a bit difficult for many to swallow. It’s in the Truth in Lending disclosure giving to borrowers of mortgage loans as well as many other types of debt.

Super simple terms: The rate that a borrower would receive from a lender if the lender charged you 0 closing costs.

Simple terms: The rate that would result if you plugged a) the number of payments b) the dollar amount of the monthly payments and c) the result of reducing the loan amount by the closing costs, into the calculator and solved for rate.

More “formal” terms: The internal rate of return of the cash flow model that includes the loan amount, closing costs and monthly payments over the life of the loan.

The one factor that does not change in a fixed rate loan is the monthly payment – right? It has the same principal and interest payment every month for 15 or 30 years. But on an ARM the payment will adjust every year after the initial 3, 5 or 7 year period. The future payment is really unknown since it’s based on the always moving index in 3, 5 or 7 yrs from now plus a set margin. So RESPA rules say for lenders to use the “current” index value as if it will be the same when the loan starts adjusting every year.

Today the most common index of the 1 year LIBOR is a hair above 1%. 1.09% I think. Adding a typical ARM margin (2.5) to that means that if LIBOR remains the same, your 5 yr arm will adjust into a rate of 1.09+2.5 or 3.59. Amazing world if Libor is 1.09 in 5 years huh?

Now factor that back into the APR calculation and assume you have a 5 yr ARM with a start rate of 4.25 paying normal closing costs and a 1% loan origination fee. You will have 5 yrs of payments at 4.25 then roll to 25 years of payments at 3.59. This results in an APR – of 3.995. Sign me up.

With all the recent turmoil in the financial markets and the resulting crush of regulation that lenders are feeling, plus the double whammy of additional “rules” to our business from HUD, one would think that we would be required to disclose “worst case” on these ARM loans. Perhaps this is bit of consumer protection that someone at HUD needs to look into?

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