New tool simplifies mortgage shopping

As indicated last week, the annual percentage rate (APR) that the law requires mortgage lenders to disclose alongside the interest rate is not a useful measure of cost to the borrower. Expressed as a percent, it makes no intuitive sense to most borrowers, does not yet cover all costs, and does not take account of differences in borrower time horizons, tax rates and opportunity costs. A much more useful measure is the "time horizon cost" (THC) that is described below.

The THC is the total cost of the mortgage in dollars over the period the borrower expects to be in the house. I will illustrate it with the example I used last week of a borrower choosing between a fixed-rate mortgage (FRM) at 5.125 percent and zero points, and another at 4.25 percent and 4.4 points. The loan amount is $100,000 and settlement costs other than points are $1,000 in both cases.

I am going to assume initially that the borrower expects to be in the house four years, is in the 15 percent tax bracket, and has an opportunity cost -- the return he can earn on other investments -- of 2 percent. The THC for the borrower on the 4.25 percent mortgage consists of the following:

Total monthly payments of principal and interest over four years: $23,613
Lost interest on monthly payments: $803
Points paid upfront: $4,400
Other settlement costs paid upfront: $1,000
Lost interest on points and other settlement costs: $380
Total costs: $30,196

From these costs, we subtract cost offsets:

The borrower's tax savings on interest: $2,548
The borrower's tax savings on points: $700
Reduction in loan balance: $7,195
Total offsets: $10,442

Total cost net of offsets: $19,754 ...CONTINUED

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