I have always been wondering why we have two different disclosures (TIL and GFE) to serve one and the same purpose… Why can’t it be just one form with all a borrower has to know? The funniest thing, though, is the fact that both The Department of Housing and Urban Development (HUD – the author of the GFE/HUD1 duo) and the Board of Governors of the Federal Reserve System (the creator of the Truth in Lending document) recommended jointly to the Congress, among other quite sensible things, I am citing:

Combining and simplifying RESPA and TILA disclosures that are provided to consumers; and requiring information about the loan originator’s role and any requirements for escrow accounts and private mortgage insurance.

The depressing part here is that the report is dated July 17, 1998. The forms have not been combined, only the GFE and HUD-1 have been modified yet to become mandatory in 2010. The Truth in Lending disclosure is still in the queue. The recent activity of the Federal Reserve Board indicates that the problem is not ignored. The Press Release dated July 23, 2009 informs that The Federal Reserve Board proposed “significant changes to Regulation Z (Truth in Lending) intended to improve the disclosures consumers receive in connection with closed-end mortgages and home-equity lines of credit (HELOCs)“.

… the key word being “closed-end”. Any Truth in Lending Disclosure carries an APR as the strategic characteristic of a mortgage, and an APR, at least how it is calculated and presented now, makes sense only for closed-end mortgages and suffers from quite a number of issues that are described in my article. The overall big issue of an APR as such, challenges the usefulness of the Truth in Lending Disclosure.

Your loan officer or mortgage broker is required to provide you with the Truth in Lending Disclosure Statement within three business days of the date that you apply for your loan. Let’s have a look what you may get, for example, here. Truth in Lending disclosure statements vary from lender to lender. There may be other specific to your mortgage sections included, such as a Balloon Payment, or a Credit Life/Credit Disability section. Many entries are provided with descriptions or are quite self-explanatory. I want to draw your attention only to those, that are either unclear or can be misleading.

The top entries (Creditor, Mailing Address, Loan Number, Applicant(s), Property Address, Preparation Date) are obvious. Then comes the notorious APR, described on the form as “The cost of your credit as a yearly rate”, which is rather a brief explanation of a very complicated matter. I refer you again to my article for details on that.

The new rules defined in the amended in 2008 federal Truth in Lending Act and effective from July 2009, oblige the lender to provide the borrower with an updated TIL if the APR changes by more than 0.125 percent. The APR can change due to a change in the interest rate, loan program or loan-related fees, the last being the most common case. More accurate information is a good thing to have, but beware: it comes with a “bonus” – a three long days’ wait. The same TILA rules now that the loan cannot close for at least three days after the borrower receives the new TIL, and that’s in addition to the seven days’ wait after the initial TIL! The purpose of these deliberate delays is to give the borrower some time to analyze the conditions and take an unhurried decision. Emergency situations, for example, if the borrower needs to refinance as soon as possible and avoid foreclosure on his home, are expected to be resolved through modification or even waiving of the waiting period. The borrower has to provide the lender with a dated written statement that describes the emergency, specifically modifies or waives the waiting period, and bears the signature of all the consumers who are primarily liable on the legal obligation, in handwritten form. Printed forms for this purpose are prohibited. However, it is still totally up to the lender to allow the expedition of the closing. If the lender refuses, the situation may become quite grief for certain borrowers, for example, when foreclosure or delay penalties are involved. Borrowers should also bear in mind another possible delay – the appraisal. It’s very likely that the lender will not order the appraisal until the last TIL review period is over and the borrower has paid the appraisal fee.

FINANCE CHARGE – The dollar amount the credit will cost you, i.e. the total of interest payments plus the total of prepaid financial charges. The estimated amount of interest paid over the life of the loan is based on the assumption that the loan will run to its original term, say, 30 years, that you will make no extra payments, that the interest rate will stay intact throughout all the 30 years, etc… Such ideal conditions are not met very often in real life, where the average age of a mortgage is around 8 years. It also includes prepaid financial charges that can be found on the GFE. The estimates of charges paid at closing had been so inaccurate for years, that the HUD finally redesigned the Good Faith Estimate disclosure form and introduced more strict lenders’ estimation reliability requirements. For more details read this article. Appraisal and credit report fees are specifically excluded from this calculation.

AMOUNT FINANCED – The amount of credit provided to you or on your behalf. This is a really confusing number. There is little, if at all, practical use of it to you as a borrower. It is calculated by subtracting prepaid financial charges from the amount of your loan. If you borrow, say, $100,000 and pay $3,000 for points, the Amount Financed is $97,000. It is rather a technical parameter for calculating the APR of the mortgage. Most importantly, you should understand that it does not make the loan balance lower – you still get $100,000 (not $97,000) for your purchase, and that’s exactly how much you have to pay back plus all the attendant fees. Financing some of the prepaid fees with the loan adds the amount to the original $100,000, making the balance higher.

TOTAL OF PAYMENTS – The amount you will have paid after you have made all payments as scheduled. The estimate is built again on the presumably unchanged conditions throughout the whole life of the loan running to its full term.

PAYMENT SCHEDULE – needs, probably, one remark, that is sometimes to be found in footnotes on the form itself. Amount of Payments includes Principal, Interest, Mortgage Insurance (if applicable) payments, but excludes property taxes and insurance, even if they are escrows.

DEMAND FEATURE – TIL only states whether your mortgage has a demand feature; it does not explain what exactly the feature implies. The details of the demand feature are to be found in your contract. It may bear the acceleration clause, which stipulates that in the event you violate a contractual obligation, the lender has the right to “call” the loan – demand its payment in full immediately. It may have the due on sale clause, which stipulates that if you sell the mortgaged property, the loan becomes immediately due and payable in full. The purpose of this clause is to protect the lender against rising interest rates.  If you sell your house and just pass the loan onto the new owner, the lender may lose money if interest rates have climbed. With this clause, the lender can rearrange the loan with the new homeowner at new terms and rates. The examples above are sensible demand clauses. However, there have been cases when lenders got tempted and abused the feature by including something called simply the demand clause claiming that the lender can demand repayment of the loan in full at any time for any reason. Such a clause covers the two circumstances mentioned above, as well as gives the lender practically unlimited power to push the borrower around in many ways, a higher interest rate under threat of calling the loan being one of them.  Luckily, such outrageous entries in contracts do not happen very often, but it’s always better to keep your eyes open and have a closer look at the item when reading the document.

FILING FEES – An estimate of the amount you will have to pay to have the mortgage documents officially recorded; charged at closing.

PREPAYMENT – is often penalized. If the word “may” is marked on your form, it means that you will be penalized for principal payments made ahead of the regular schedule. It is sort of weird to oppose the word “may” to “will not”, but they must have had their reasons. Most importantly, it should not confuse you or give you a feeling, that the penalty is more likely not to be imposed if it’s “only may”.  If the lender is not planning any penalties, he will make it clear by marking “will not”.

Now, isn’t it too many issues for a one-page document? Designed to complement the GFE and assist a borrower’s choice of a mortgage plan and provider, TIL, on the contrary, ends up being quite confusing and in many cases misleading. I won’t say “put it aside and never look in it”, because it discloses certain borrower’s responsibilities you must be aware of, but I will advise against trusting it too much as a comparison tool. It bears the same issues as the GFE – the rates provided are obsolete the next day and if you get quotes from several lenders on different days, it makes the comparison based on the TILs inaccurate.

The bottom line: use both the TIL and the GFE to make your choice, never rely only on one of them; and remember – they both are just estimates. When you sign the TIL at the bottom of the page, it is neither a contract nor a commitment to lend – it only indicates that you received the document on a certain date.

The recently introduced new Good Faith Estimate (GFE) form triggered certain changes in the settlement documentation chain. Its long-time associate the Housing & Urban Development Settlement Statement (HUD-1) form has undergone a makeover, too. The guidelines for the usage of both documents went into effect on January 16, 2009, but they will become mandatory only on January 1, 2010.

Unlike the GFE that provides only the estimation of the settlement costs, the HUD-1 describes the real deal. The new HUD-1 form has clear references to the corresponding items in the GFE and a special section, where you can compare the GFE promises and their HUD-1 implementations. The Statement itemizes all charges imposed both on you as a borrower and the seller for the real estate transaction. It gives each party a complete list of their incoming and outgoing funds. Fees associated with the transaction but paid prior to closing are also included. They are normally marked “POC” for Paid Outside of Closing. RESPA states you should be given a copy of the HUD-1 at least one business day prior to settlement. In real life, however, entries may still be coming in a few hours before closing. The form is filled out by the settlement agent who will conduct the settlement, so make sure you have the name, address, and telephone number of this agent if you wish to inspect the form prior to closing. Have the agent go through the details with you and do not hesitate to ask about any suspicious increase (or decrease) from the estimate, about any charge you do not understand. Do not feel shy to find out exactly what you are paying for.

Before January 1, 2010 you may still be provided with old GFE and HUD-1 forms. These forms bear their old issues, incomprehensibility being one of them. If the potential lender only cared to offer you the old standard forms, you may give the whole deal a second thought. Note, if the GFE presented to you is a new standard, the following HUD-1 must also be new. The old GFE couples with the old HUD-1 only.

What good is the Good Faith Estimate you received from your potential lender? Let’s see…

At first sight, the information provided seems gold – origination fees, appraisal fees, credit report… you name it! And then you get several Estimates from different lenders, and compare, and think that you have made a fair choice until… well, actually, the closing. To many people it came as a shock – the actual cash charges happened to be a lot higher than any GFE had ever told them. The problem was, and still is for the old forms, that the document bore no clear indication of the possible changes in the prices. People relied too much on numbers that were just estimates, sometimes highly inaccurate ones. Moreover, no penalty was imposed on lenders, who intentionally provided inaccurate numbers. Originally intended to help a homebuyer compare mortgage offers and select a program best suited for his particular situation, the document ended up in being confusing and, what is worse, misleading. For years, the prices and charges quoted in too many GFEs had little to do with the real charges that borrowers had to face at closings. Tempers rose, and finally the government paid attention – the new Real Estate Settlement Procedures Act (RESPA) guidelines went into effect on January 16, 2009. The new Good Faith Estimate (GFE) and Housing & Urban Development Settlement Statement (HUD-1) can already be used, but become mandatory only on January 1, 2010.

A fair question – what difference does it make if it says on the paper in block letters “NO WORD OF TRUTH HERE”, I’ll just throw it away – gets a hopefully effective and efficient answer in the new RESPA. The year of 2009 allows lenders to choose which forms to use, but the usage of the new forms also implies, that the lender has to comply with the other new requirements, namely:

• Use the new standardized Good Faith Estimate form (GFE). Unlike the old form, which was rather a flat list of items, the new one has a clear structure of categories, no “junk fees”;
• Provide a clear summary of the loan terms and total settlement charges on page one of the GFE. Tests proved that the summary is actually useful for comparison-shopping. However, you should always bear in mind the unavoidable issues of all mortgage price quotes – they get outdated within 24 hours, mainly the Interest Rate & Points if they are not locked. You cannot lock them with every lender you comparison shop. Even if all lenders provide you with perfectly accurate GFEs, but all of different dates, the comparison results may still be quite misleading;
• Provide more accurate settlement services cost estimates on the GFE. The costs subject to changes are differentiated from the unchangeable costs, there is a special section explaining which charges can change (and how much) and which cannot;
• Ensure borrowers are aware of final loan terms and costs at settlement
• Clarify HUD-1/HUD-1A instructions
• Clarify HUD’s current regulations concerning discounts

The new GFE also offers a special tradeoff table section, where the lender can suggest a couple of alternative mortgage plans based on the borrower’s situation. The tests conducted by HUD proved this section very useful for borrowers. Unfortunately, lenders are not required by law to fill it out, so if you want this comparison information, you have to ask for it explicitly.

Now, how do you know if the GFE you have received is an old or a new form? Does it look like this or like that? The former is the old form, and the latter is the new one. It is more or less clear what to expect from a lender with a new form, as it has already chosen to comply with all the other regulations accompanying the new GFE and HUD-1. An old-standard GFE, however, still bears its issues: poor comprehensibility, possible inaccuracies due to many reasons including lack of legal liability for errors. If you choose to commit yourself to an offer described by an old form, I would suggest two steps to prevent too much disappointment and stress at the closing:

1. ask the lender to provide you with the HUD-1 form at least 1 day prior to closing, not at closing itself – you have to have time to compare the HUD-1 and the GFE and prepare questions over everything that seems unclear;
2. make it clear to the lender, that if the actual charges at closing happen to be a lot higher than declared in the GFE, you will NOT close.

No matter if the form is new or old, it is an estimate and should be treated as such. Certain unintentional inaccuracy may occur, too, as, for example, large lenders operating nationwide are not always familiar with local customs, for example regarding the buyer’s cost for title insurance. In one county it is customary for the seller to pay for title insurance, while in the adjoining county the buyer pays it. However, you personally do not always have to follow the customs of the area, for your mortgage you can negotiate who pays what and on what terms.
And finally – close at the end of the month. As all mortgage payments are due on the first of the month, you can avoid or reduce the prepaid interest due by closing on or near the last day of the month.

As many other borrowers, you probably got deceived by the APR’s apparent similarity to the interest rate and assumed that “locking the rate” means locking all the rates involved. Unfortunately for borrowers, that is not the case. The APR does not only include the interest rate and the points, which do get locked, but also the closing costs, origination fees and other cash-based parameters, which do not get locked, ever. When you lock the rate, you lock the interest rate and the points only. In the time between the locking and the closing, the lender is free to change all the other included into the APR fees at will. Some lenders are not shy to exercise the right. An increased APR means that at closing you will have to pay more than the original estimation of charges. It is always hard to say whether it originally was an intentional underestimation of costs presented by the lender in an attempt to attract a customer, though.

The Annual Percentage Rate (APR) was created with good intentions to make complicated things if not simple, then at least simpler. It even works in many cases! Unfortunately, it also fails in just as many other cases, which sort of devaluates it as a universally reliable tool.

The APR looks a lot like an interest rate, because it is also a percentage. However, it is quite a different parameter. The APR is the sum of the interest rate and a theoretical percentage rate derived from other then the interest, fees associated with a mortgage: points, pre-paid interest, origination fees, attorney and notary fees, closing agent’s document preparation fees, PMI. Third party services, such as appraisals or credit reports, are not included. The purpose of this rate is to summarize all the costs of a mortgage into one number and help a potential borrower make a more informed choice. The borrower should be able to compare mortgages by comparing their APRs. Ideally, a mortgage with the APR of, say, 6.25% should be a better deal than a mortgage with a 7% APR, implying that the latter’s closing costs are higher. The APR is usually higher than the quoted interest rate, but it does not influence your real monthly payments. The monthly payments are dependent on the interest rate; the APR is a purely technical theoretical parameter developed to assist the choice of a potential borrower. It immediately gives one the overall idea of the costs involved. Even though in real life these costs are upfront and paid in a lump sum, the artificially created APR assumes, that the total amount of the origination fees & Co is rather spread over all the years of the loan’s life. A little bit of this money is allocated to each monthly payment, as if you were paying the origination fees bit by bit all through the years. It is only an assumption in order to produce a number called the APR in order to help you as a borrower to compare different mortgage offers. Federal law requires that the APR be disclosed alongside the actual interest rate. For example, if you are looking at two otherwise identical offers – one of 5% interest rate and 6.5% APR, the other of 5% interest rate and 7% APR – the conclusion is obvious: the former offer is better, because you get the same mortgage with lower closing costs. Unfortunately, this is about the only situation, when the APR gives us a fair and reliable comparison. If the interest rates are different, the APR can be quite misleading. For example, if we have two mortgage offers with identical APRs of, say, 8%, but different interest rates of 5% and 5.5%, the decision immediately becomes more complicated than these two numbers. Why is one rate lower? How many points does it cost? Is it worth for you personally paying the points? There are other issues as well.

To explain that I will first have to use an oversimplified and unrealistic example: assume you have a basic (no PMI, no escrow etc.)30-year fixed rate mortgage for $100,000 at 5%. The closing cost you $10,000. Each monthly payment consists of a certain amount towards the principal to repay $100,000 and an amount towards the interest. The APR calculation does not simply add the $10,000 closing costs to the balance; it rather treats it as a second no-interest loan with a term equal to the term of the main mortgage. The easiest way would be to take the $10,000 and distribute it evenly throughout all the 360 months of the 30 years, but it would be an absolute amount, no more descriptive or comparative than just knowing the closing costs. To create a relative parameter, the closing costs pay off amount allocated to each month is a percentage of the outstanding balance of the main mortgage; the balance shrinks with time as it gets paid off, so the amount derived from it as a percentage also changes. The APR is the percentage rate that provides enough flow to pay off $10,000 through 30 years plus the interest rate of the mortgage itself. As you can see, the calculation is not all that simple after all, that is why the use of specialized calculators is highly recommended when checking the APRs provided by lenders.

Why check?

The APR provided by a lender assumes that the borrower sticks to the mortgage for all the 30 years of its life. The closing costs are spread throughout all the 30 years, which means that the pay off amount allocated to each month is lower than if you keep the 30 year mortgage for 10 years only. The same amount spread over a shorter period of time gives us a higher monthly payment towards the upfront costs, i.e. a higher APR. The point here is: if you know that you will not keep the mortgage for all its term, do not rely on the lender’s APR. Use a calculator where you can enter the expected period to estimate the real APR of the mortgage offers you are considering. You can also fiddle with the down payment and points amounts to see which combination produces a better APR.

There are several other situations where an APR-based comparison fails to perform: cash-out refinancing vs. the cost of a second mortgage; a mortgage with negative points; a HELOC.
While comparing the costs of a cash-out refinancing with a second mortgage, a borrower is provided with the APRs of the second mortgage and the new mortgage s/he refinances into. That’s what s/he is offered to compare. However, the real life equation is more complicated: the losses caused by the usually higher interest rate of the refinanced into mortgage are not taken into account. For example, you have a 6% mortgage with the outstanding balance of $100,000 and 10 years to go. You need another $20,000, i.e. either a second mortgage of $20,000 or a new mortgage of $ 120,000. If the interest rate on the $120,000 mortgage is higher than 6%, a difference in the cost of each dollar from the $100,000 borrowed the old way and the new way will occur. The refinancing APR does not take this difference into account, thus failing to describe all the costs of the refinancing, thus making the APR comparison of these two solutions inaccurate and misleading.

There are no universally agreed rules as to how to calculate negative points into an APR. Every lender has it his own way, which makes the APR provided rather useless – it cannot be used for a reliable comparison of products.

A proper HELOC should not involve any costs non-rechargeable at closing. This way the APR is just equal to the interest rate. A borrower should rather be concerned about the initial teaser rate and the rate margins and caps, while selecting a HELOC product. The APR disclosure is required by law, but not the disclosure of caps or margins!