Unraveling the Complexities of a Loan
QUESTION: We recently refinanced our house. Our loan papers say the annual percentage rate-or APR--is 10.837%. But we were quoted a 10.25% interest rate. How can that be? I understand how the actual APR can be higher than the interest rate on a deposit, where compounding of interest occurs. Also, we borrowed $250,000, but we are receiving only about $248,000, even though we believe that we took advantage of a no-points, no-fees refinancing special offered by our bank. Is this all tied together somehow? --E. H.
ANSWER: The questions you raise are interesting and important. But, unfortunately, because these matters are also complicated, many consumers do not understand them. Let’s try to unravel what happened in your case and how this common scenario applies to other home loans.
To start with, we should explain that your lender cooperated with us and explained the particulars of your loan. When you refinanced your house for $250,000, you took advantage of a special promotion that waived the fees and points typically tacked onto these deals. Further, the nominal interest rate for the first five years of your adjustable-rate loan is 10.25%, just as you thought. So what happened? Why is the bank telling you that your interest rate is 10.837%?
First, although you were not charged loan-origination fees and points, you were required to prepay the first month’s interest on the loan, as you would be with virtually every lending institution. And rather than make you come up with that money from your checkbook, the bank deducted it from the loan proceeds, leaving you with $248,000.96 in cash from the $250,000 that you borrowed. You can decide for yourself what this prepaid interest should be considered. Interest typically is paid in arrears, not in advance. So, is the prepayment a fee? Some lenders say “yes.” Your lending institution says only that it is an interest prepayment.
Now, because you are receiving only $248,000.96 but are obligated to repay the entire $250,000, federal truth-in-lending laws require lenders to divulge what this actually means to you in terms of the interest rate. (They don’t have to tell you where the money goes, just how the deductions affect the interest rate.) In your case--and allowing for other special deals that you took advantage of--the effective annual percentage rate for the first five years of your loan is 10.837%.
According to our experts, it is not at all uncommon for banks and savings and loans, just as they did with your first month’s interest, to take their fees and loan points from the loan proceeds before the borrower receives the money. In these cases, the APR would also be higher than the initially quoted interest rate, since the loan proceeds received by the borrower would be less than what must be repaid over the life of the loan.
For example, if a homeowner borrows $50,000 at 10% and is charged an additional two-point (or 2%), one-time fee by the institution for making the 30-year loan, he or she will actually receive just $49,000. However, because he is required to repay the entire $50,000, his effective interest rate, or APR, is 10.25%. Although thrift institutions are required to divulge this information to borrowers, consumers are often confused by the calculations and agree to the loan and its terms without fully understanding it. As your experience suggests, borrowers should not be afraid to question--repeatedly if necessary--their lenders, until all terms of the loan are understood.
Paying the Piper for IRA Withdrawal
Q: I was unemployed last year and was forced to withdraw money prematurely from my individual retirement account. I withdrew only the interest earned in one particular account, just when that account reached maturity. I realize that I must pay income taxes on this money. But do I also have to pay the penalties for premature withdrawal? To me, the interest had not yet been folded into the principal of the IRA. So I am thinking that it wasn’t yet tax-deferred income and subject to the penalty. Is this right? --P. C.
A: That’s pretty creative thinking, but, unfortunately for you, the Internal Revenue Service doesn’t agree. According to federal regulations, the premature withdrawal penalty--10% of the amount plus any applicable income taxes--applies to any early disbursement, whether it is interest or principal.
Social Security ‘Bias’ Against Bachelors
Q: A bachelor pays the same Social Security taxes as a married person. However, because a bachelor leaves no spouse or children, if he dies before reaching retirement age, or even after, no widow or minor children ever receives the benefit of all the contributions he has made into the program. In this “Why me, Lord?” generation, doesn’t this constitute some sort of discrimination? --W. R.
A: Oh, we suppose you can argue almost anything these days. But the plain and simple fact is that the laws governing Social Security provide only for minor children and spouses to receive the benefits of a deceased wage earner.
Furthermore, the actuarial tables used to help determine benefit levels are based on these eligibility laws. If these laws were changed to admit additional beneficiaries of a deceased wage earner’s Social Security payments, there would be more people staking a claim to the same pool of money--or there would have to be another sizable increase in Social Security taxes.
Social Security representatives often compare the system to an insurance policy. Some people use their policies; others don’t. But even if we don’t ever draw on these policies, few of us decide to do without some homeowner, car or life insurance. We purchase the policies, year after year, “just in case.”
The same is true with Social Security. Some wage earners pay a lot into the system and never have the chance to draw benefits. Others get more out of the system than they ever contributed. “It’s not 100% equitable,” says one representative. “And it never can be. That’s just how it is.”
