True Cost of Variable Rate Mortgage Funds

rate distribution

uniform

normal

initial fixed term

5

7

rate lower bound

0.03

rate higher bound

0.09

initial interest rate

0.04

payoff year

10

origination costs (%)

2

Regulation Z, the result of the Federal Truth in Lending Act, was promulgated in 1968. Subpart B, among other things, covers rules for calculating annual percentage rates, commonly referred to as APR. At that time lending was predominately done with fixed interest rates. Unfortunately, the artificial assumption that the loan will be outstanding for its full term means that the APR disclosure is usually inaccurate even in the fixed rate case. When variable rates are involved, reality diverges farther from APR. This Demonstration shows how connecting the computation to the actual term produces a more accurate true cost of funds (TCF), even if rates are variable.