Why The Higher Rate Loan Is Often Better

The short answer is "Because it costs less"



There is always a trade-off between rate and cost on a given loan type. If you want the thirty year fixed rate loan half a percent lower than everybody else is getting, you're going to pay for it in the form of discount points. The higher cost always goes with the lower rate. You might as well consider it a law of nature in the same league as gravity, because it is a law of economics. If you don't want to pay high costs, you end up with a higher rate. End of story. There are all kinds of games that can be played with loan quotes, but the fact of the matter is that of the tens of thousands of rate sheets I've seen from over two hundred different lenders from A paper all the way down to hard money, every single one of them conforms to this fundamental truth. A 6.00 percent loan will cost more from the same lender at the same time than a 6.50 percent loan of the same type. Some lenders have different trade-offs than others because they are aiming at different target markets. I could tell you about lenders that rarely have a rate below par on their sheet, and lenders that rarely have a rate above par, par being the point at which there are no discount points to get the rate, but no yield spread either. Some lender's par may be lower than others, or higher. The par on a completely different loan type, or loan program, will be different. Par varies with time, the qualifications of the borrower, the type of loan they desire, the type of documentation they are providing, and other concerns as well.



The cost of a loan is sunk. Once you have the loan, the money you spend to get it is gone, whether you paid it out of pocket or rolled it into your balance. If you sell or refinance before you have recovered it via lower interest costs, you don't get it back. Actually, if you roll it into your balance, the money isn't gone, because you still owe it and you're paying interest on it. If you sell, it will mean you get less money, and if you refinance again, your balance will still be higher. Paying it out of your pocket is no better, because you could be investing that money, likely at a higher rate of return than the rate on most loans.



Now here's a very old rate sheet I saved from a random lender. The rates are much higher now. All of the lock periods are thirty days. I'm going to presume a $400,000 total loan, as if you're doing a cash out refinance to a specific loan to value ratio, but the principles are the same no matter the loan size.

Rate 5.25 5.375 5.5 5.625 5.75 5.875 6 6.125 6.25 6.375 6.5 6.625 6.75 6.875 7

discount 3.898 3.221 2.6 2.01 1.452 0.963 0.615 0.252 -0.063 -0.381 -0.661 -1.039 -1.27 -1.511 -1.577

pts $ $15,592.00 $12,884.00 $10,400.00 $8,040.00 $5,808.00 $3,852.00 $2,460.00 $1,008.00 -$252.00 -$1,524.00 -$2,644.00 -$4,156.00 -$5,080.00 -$6,044.00 -$6,308.00

total cost $19,092.00 $16,384.00 $13,900.00 $11,540.00 $9,308.00 $7,352.00 $5,960.00 $4,508.00 $3,248.00 $1,976.00 $856.00 $0.00 $0.00 $0.00 $0.00

net $ $380,908.00 $383,616.00 $386,100.00 $388,460.00 $390,692.00 $392,648.00 $394,040.00 $395,492.00 $396,752.00 $398,024.00 $399,144.00 $400,000.00 $400,000.00 $400,000.00 $400,000.00

Alternatively, If you owe $400,000 and roll the costs into the balance, it becomes the following. Actually, the costs are mostly higher because points are computed based upon final loan amount, while I was too lazy to recompute from the previous example. Also, the maximum conforming loan is $417,000 currently, so going over that would cause the rates to rise notably, but assuming you have a 7% interest rate now, this is how quickly you would recover the costs of the new loan:

Rate 5.25 5.375 5.5 5.625 5.75 5.875 6 6.125 6.25 6.375 6.5 6.625 6.75 6.875 7

total cost $19,092.00 $16,384.00 $13,900.00 $11,540.00 $9,308.00 $7,352.00 $5,960.00 $4,508.00 $3,248.00 $1,976.00 $856.00 $0.00 $0.00 $0.00 $0.00

loan $419,092.00* $416,384.00 $413,900.00 $411,540.00 $409,308.00 $407,352.00 $405,960.00 $404,508.00 $403,248.00 $401,976.00 $400,856.00 $400,000.00 $400,000.00 $400,000.00 $400,000.00

int/month $1,833.53 $1,865.05 $1,897.04 $1,929.09 $1,961.27 $1,994.33 $2,029.80 $2,064.68 $2,100.25 $2,135.50 $2,171.30 $2,208.33 $2,250.00 $2,291.67 $2,333.33

save/month $374.81 $343.28 $311.29 $279.24 $247.07 $214.01 $178.53 $143.66 $108.08 $72.84 $37.03 $0.00 $0.00 $0.00 $0.00

breakeven 50.94 47.73 44.65 41.33 37.67 34.35 33.38 31.38 30.05 27.13 23.12 0.00 0.00 0.00 0.00

*over $417,000 kicks into non-conforming loan territory



People shop loans by payment. They shouldn't, but they do. Furthermore, a lot of people seem to get quite a stroke out of bragging that they have a low interest rate. But if you add $19,000 to your balance and only keep the loan long enough to recover $15,000 in interest, you've gotten a negative 20% return on your money - not including the time value of money. Furthermore, this money usually equates to the fact that you're going to have a higher balance and end up paying more money and higher interest on your next loan.



Now, it may be counter-intuitive, but it is easier to qualify for a loan with a lower rate, because the payments are lower, and therefore the Debt to income ratio is better. So any time somebody tells you that you didn't qualify for the same loan at a lower rate, you know it's nonsense. If you qualify for the program at all, you qualify more easily with a lower payment. This begs the question of whether you qualify for the program at all - your credit score could be too low, or it might not allow a loan to value ratio or debt to income ratio or any of many other situations you find yourself in, but if you qualify for the program, you will qualify at the lower rate. It may be smarter to want the higher rate, but that can be effectively eliminated by debt to income ratio.



So that's why low and zero cost loans are not popular. Most people focus in on either payment or interest rate, and when they discover that the low or zero cost loan means a higher interest rate, they're not interest. But if you don't keep the loan long enough to recover the additional costs, you're wasting money. Only a true zero cost loan can have you ahead immediately, but advertising or selling zero cost loans is like King Canute trying to command the tide to turn. Most people aren't interested.



There are other considerations. I've been telling people interest rates are going to rise for quite some time, and so rates gotten now are not going likely to be equaled for quite a while. This has now become quite apparent, for instance, if you've been pricing loans lately as opposed to when this rate sheet was valid a few months ago. If you're not intending to sell any time soon, it's likely to be a good idea to pay part of a point or even a full one, as you're likely to be keeping the loan longer, and the median time between refinancing is likely to rise. Nonetheless, there are limits on the size of any bet you want to make, and when you pay costs up front for a loan rate, you are betting that you're going to keep it long enough to more than recover those costs. For quite a few years now, the lenders have been winning the vast majority of those bets.



Caveat Emptor