Balsamic Vinaigrette, Buttermilk Ranch & Your Mortgage.
So I was at McDonald's today. (Bring it on, indignant foodie brigade! You'll pry my french fries out of my cold, greasy, dead hands.) I was confronted at the palais de graisses saturées with the "Under 400 calorie" menu that they've rolled out to go with the 2012 London Olympics. A copy is below in case you've not sullied yourself with such things lately.
It was the salads that caught my eye. Maybe not for dinner, but for the purposes of explaining this article. Because salads - or rather, salad dressings - make a wonderful analogy for explaining APR and interest rates.
Salads are Kind of Complicated.
So, you get your basic side salad and it's 20 calories. You nibble, you gain very little weight, you feel full, end of story. But a salad of just iceberg lettuce, cucumber slices and a couple of cherry tomatoes won't get you featured in Time Out Magazine. People start getting creative. The good folks over at "Cooking Light" explain in a nifty slideshow how a restaurant salad can quickly rack up over 1500 calories, not to mention the fat & sodium involved. The more stuff you put on your salad, the more time you'll have to spend at the gym later to work it off. But it's so easy when you're ordering the salad to say, "OK, I can have these croutons now, it's no big deal."
We've been doing this for so long that it's become a cliché - "a minute on the lips, a lifetime on the hips."
If you're working with a weight loss deadline - say, swimsuit season or trying to squeeze into a fancy halloween costume - suddenly the amount of exercise you'll have to do to neutralize the ranch dressing gets compressed into a far shorter time period. 500 extra calories is a lot harder to work off in a week than slowly over a few months. You start giving some thought to your order. Hold off on the croutons, swap out the buttermilk ranch dressing for a low-cal balsamic vinaigrette.
From Our Lettuce to Your Cabbage.
So when you go to buy money from a bank or a mortgage broker, you're faced with a situation very similar to ordering a salad. Every lender will offer you a different base interest rate - that's like every restaurant offering you a different combination of vegetables on a bare, undressed salad. Some banks will be small local ones, others big national ones, just like some salads are organic & locally grown while others are covered in pesticide & imported from Mexico. It's your choice as to which way you want to go.
Beyond the basic lettuce, though, there's all of the extras consider. When dealing with salad, you're talking about dressings, croutons, and maybe those tasty little sesame sticks. In the case of the other green stuff - borrowed money - it's all of the lender's assorted fees & commissions. And in the lending world, all of that stuff found in the difference between the interest rate and the APR.
Lenders charge to give you a loan. They are selling money. They have to turn a profit. They may say it's a "no-fee" loan up front to get you talking to them, but the fees may actually be wrapped up in your monthly payments instead. The government has recently started requiring restaurants to disclose the calorie content of their dishes. Similarly, the Truth in Lending act requires lenders to disclose any hidden fees that you will be required to pay, either at closing or folded in.
I'll give you an example.
That chart above explains it nicely. But there's a problem. See, the APR they disclose to you is based on the thought that you'll be in the place for the entire life of the loan. Most people are not planning on staying in their home for 30 years even though they get a 30 year mortgage. So while it's all well and good that the banks are disclosing their APRs to us, it doesn't really matter if you're planning on taking off much earlier.
Shorter-Term Loans are Kinda Complicated, Too.
Remember when I started talking about dieting on a deadline up above? That's coming back now. Just like that 1500 calorie salad is a lot more of a challenge if you're trying to drop 20 pounds in a short time, the actual APR that you would be taking on will be much higher than the quoted amount of you're planning on paying off the loan in, say, 7 years.
You're still borrowing $50k plus $2k in finance charges. You're still going to have to work off those extra calories - the finance fee salad dressing, if you will - but you'll have less time to do it. Remember, you still have a loan for $50,000 at 3% interest. But with the finance fees included you're suddenly paying off the balance plus the fees in a shorter amount of time. $2000 spread out over 84 months is a lot tougher than $2000 over 360 months.
Let's take a look at what the real APR would be for someone who leaves after 7 years. I've done another handy chart below.
In Monday's article, the savings from paying discount points and a higher down payment at closing increased with a longer stay in the property, from 9% after 5 years to 35% over the life of the loan. This is also true for APR. The longer you stay, more fully distributed those fees will become, and the closer your real-life APR will get to the numbers quoted by your lender. It will take you less time to get to your break-even point.
Wrapping it Up to Go.
It's best if you can find a mortgage broker with no difference between the actual interest rate and the APR. However, if the best interest rates you get are quoted by lenders that are going to charge you fees, make sure you calculate your own actual APR or talk with your Realtor, accountant or a neutral and mathematically gifted individual to figure out if the cost in fees will be more than the difference in quoted rates.
Let's look at another handy chart to help explain what I mean.
So next time you see APR don't be confused and don't mentally check out of the conversation. Lenders are going to rely on you being both a) confused by the term and b) too ashamed to ask what it means. For a high-cost lender to voluntarily explain APR to you in a clear manner would be shooting themselves in the foot. Just remember when the term comes up that it's like figuring out what to get on your salad. High APR is like high-fat dressing. The best thing for your financial health is to stay away from the extras and find the most basic, low-fat loan you possibly can.
(Aren't you proud of me? I made it all the way through that without a single "bacon bits" pun!)