SANTA CRUZ (January 18, 2009) - Of all the documents that must be signed, none of them is more confusing to the borrower than the one that is supposed to explain the true costs of borrowing money. It is the Truth in Lending Disclosure Statement and is one of many disclosures that must be sent to the borrower at the beginning of the loan process.

There are two terms developed by our federal government on this page that never fail to generate calls, questions and confusion. The “Annual Percentage Rate”, otherwise referred to as APR, is an attempt to give the borrower a single number by which he or she can compare one particular loan with all other offerings. The other term is “Amount Financed”, which borrowers assume should be the amount of money that they are borrowing but is not.

The most important document that a borrower signs when obtaining a mortgage is the NOTE. The NOTE specifies the interest rate that must be paid over the term of the loan. There are fixed rate notes and adjustable rate notes. In the case of a fixed rate note, the interest rate for the life of the loan remains constant and the payments are constant and are based on the note rate. The note also specifies when payments are due, what the late penalties are, when the note must be paid off, etc. The interest rate varies for an Adjustable Rate Mortgage (ARM) and it is the NOTE that details how that rate will change over the life of the loan.

There are two interest rates that are presented for every loan scenario: the APR and the NOTE rate. The APR attempts to calculate an effective interest rate that takes into account the fact that there are costs to borrowing money. These costs are referred to as closing costs. The APR is, by definition, “the cost of your credit as a yearly rate”. Spreading the typical closing costs over the life of the loan increases the effective interest rate by about one quarter of one percent. The higher the closing costs, the higher the APR.

Two competing lenders could each be offering the same interest rate on the same loan amount but if one charges $6,000 for closing costs and the other charges $12,000 for closing costs, the APRs would be much higher for the loan with higher closing costs.

Unscrupulous mortgage originators who try to take advantage of borrowers by advertising low rates or low loan origination fees and then try to make up for it by charging unusually high processing or other fees can be (theoretically) weeded out by the conscientious consumer who compares APRs.

But this concept is a confusing one for virtually every borrower. I remember arranging the refinancing for a successful San Francisco tax attorney who had several college degrees. He was also a CPA. I was not surprised that he called me after receiving the Truth in Lending Disclosure Statement to ask me why the APR was not the interest rate that we had agreed upon. Although a brief explanation sufficed, it is a common source of confusion.

To top off the confusion, APRs are not always calculated the same by each lender. Furthermore, calculating an APR for an adjustable rate mortgage creates mass confusion among lenders. Calculating the APR for ARMs requires a prediction of what rates will do in the future, which only readers of crystal balls are able to do.

The other term on this disclosure that creates endless questions is the “Amount Financed”, which every borrower believes ought to be what they are borrowing. However, by definition, the “Amount Financed” is equal to the loan amount minus the prepaid finance charges, which are the lender’s closing costs plus the escrow fee plus prepaid interest.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 of email him at Peter@SantaCruzHomeFinance.com.