The Tradeoff between Rate and Cost in Real Estate Loans
The question every good loan officer hates is "What is your lowest rate?", usually the first thing in a phone conversation. People think that this sort of rate shopping is going to help them. The fact is that it almost ensures they are going to get ripped off or worse, as millions of people have discovered in the last few years - and most of them don't understand that this attitude is precisely what got them into the toxic loan that ruined them financially.
First off, everybody doesn't get the same choices. As I've said before, somebody who can prove they make enough money, has a history of paying their debt, and offers the lender a situation where there's 30 percent equity (or more) gets a different set of choices than somebody who can't prove they make enough money, has a questionable history of paying debt, and wants to borrow 100 percent of the property value (or more).
Second, different loans get different rate-cost tradeoffs. The loan that most people seem to consider the most attractive loan, the thirty year fixed rate loan, is always the most expensive loan out there. It always has the highest set of cost/rate tradeoffs. Why? Because on top of the cost of the money, you are essentially purchasing an insurance policy that says your rate will not change for thirty years. Even when long and short term rates are inverted there is a premium charged for the thirty year fixed rate loan. It makes a certain amount of sense; insurance policies are never free, and the thirty year fixed rate loan is the most desired loan out there. Simple economics: Higher demand equals higher price. Goods perceived as more valuable carry a higher price tag. So if you're looking for a thirty year fixed rate loan, and all you say is "What is your lowest rate?" you are likely to get quoted a rate from a Negative Amortization loan, the most toxic, least desirable loan out there, because it carries the lowest nominal rates. Even today with those gone, there are replacements which may not be quite so toxic, but are certainly nothing you actually want to be signing a contract for. If you want to argue with me, consider the meltdown we had for several years caused by toxic loans. If interest rate (or worse, payment) is your only datapoint from the various loan providers you talk with, you are likely to do business with the one who quotes you the negative amortization loan, not the thirty year fixed rate loan. Matter of fact, the loan provider who tells you about the loan that you really wanted is least likely to get your business in this scenario, because you're focusing in on the red cape of rate and payment when you should be paying attention to other things.
Third, and most importantly, for every situation and every loan type, there is more than one rate available. Why is this, you ask? It seems obvious to you: Why not just choose the lowest rate, which has the lowest payment? It takes a little examination to see why.
The difference between the rates is in cost of the loan. There will be a rate called par. This is the rate at which the lender will loan you the money straight across. They don't charge you any money (discount points) to get a lower rate. They don't pay any of the costs of the loan. Getting a loan done really does take a minimum of about $3000 in closing costs (actually, that figure is for California, which believe it or not is one of the cheaper states to get everything done in - every other state I've done business in has higher closing costs), plus whatever the lender makes in order to do your loan. Whether points and closing costs are paid out of your pocket or added to your mortgage balance, you are still paying them. Indeed, when shopping for a mortgage, the phrase "nothing out of your pocket" from a prospective loan provider should immediately put you on guard.
For rates below par, you must pay discount points. This is an upfront incentive to a lender to give you a rate lower than they otherwise would. Every situation is different and should be analyzed with numbers specific to that situation, but as a rule of thumb: Unless you're getting a thirty year fixed rate loan and you have a history of keeping loans at least five years before sale or refinance, you should avoid paying discount points if you can, and accepting a rate with a bit of yield spread to offset origination is probably a good idea, even though it will be at a higher rate. The lower payments you get with the lower rate are rarely worth the cost of adding the points to buy that lower rate to your mortgage balance. People who don't qualify for A paper may not have this option, but more people qualify A paper than think they do. These days, with true subprime essentially extinct, it's A paper, what professionals used to call "A minus" which is essentially for people who barely miss qualifying A paper, or nothing.
For rates above par, the lender will actually pay part or all of your closing costs. It's rare that they will actually put money in your pocket, but it can happen. Note that this is different from a stealth "cash out" loan that adds the cash you get to your mortgage balance, charges you closing costs, and often puts a couple points on the whole amount of your new mortgage, and so where you've been told you're getting $2000 in your pocket, there may be $20,000 or more added to your mortgage balance. This is where the lender is actually paying part or all of the costs of the loan, so it is neither coming out of your pocket nor being added to your loan balance. This is called a "yield spread" or "rebate". Yield spread can be thought of as the opposite or negative of discount points, and discount points can be thought of as a negative rebate. There are never both discount points and yield spread on the same loan, although there can be origination points on loans where there is a rebate. I still believe it's a material misrepresentation, but that's the way Congress and HUD now require it to be done.
The critical fact that most consumers never figure out for themselves, and certainly never realize the implications of, is this: The vast majority of borrowers don't keep their mortgage loans very long. The median age for a mortgage was roughly two years when I wrote this and is still under 3 years. Fewer than 5 percent of all loans are five years or older. If you're the exception, bully for you. Otherwise, take heed and remember this fact: Whatever costs you pay for a mortgage are sunk at the beginning. This money either comes out of your pocket, or goes onto your mortgage balance. If it goes onto your mortgage balance it is even worse than paying it out of pocket because this money you owe sticks around a very long time and you pay interest on it. When you sell or refinance, (or when your rate starts adjusting), the benefits stop. They are over. Done with. If you haven't recovered the costs you paid to get a lower rate by that point in time, you have made a losing investment. Period. End of story. No chance for recovery. Matter of fact, even if you are technically ahead at that point in time, you can go negative later.
Let us consider a $270,000 loan. Smallish for California, but large in most other areas of the country. As I said earlier, real closing costs of doing this loan are somewhere in the neighborhood of $3400. Rates are lower now, but here are some real options that were available from one lender when I originally wrote this article:
You could do a thirty year fixed rate loan at par of 5.75 percent. Or you could get a one point rebate at 6.25, or you can pay one point and get 5.25 percent. Rates at this update are much lower than this, but this is still a good example to use so I'm going to leave the original figures untouched.
Assume you roll any costs into your mortgage like most folks do. Your starting loan balance will be $276,162 if you choose the 5.25% rate. If you choose the par rate of 5.75%, it will be $273,400. If you choose the one point rebate rate of 6.25%, your balance will be $270,666. These are real examples off the first rate sheet I happened to look at when I wrote this.
Let's compute the linear break evens: The 6.25% rate cost you $666 to get (Closing cost less dollar value of rebate). You pay $1409.72 in interest the first month. The 5.75% rate costs you $3400, and you pay $1310.04 in interest. The 5.25% loan cost you $6162 (Closing cost plus dollar cost of discount), and you pay $1208.21 interest the first month. Difference in cost divided by difference in interest.
6.25% versus 5.75% loan: $2734/$99.68 = 27.42 months.
5.75 versus 5.25 loan: $2762/101.83 = 27.12 months
5.25 loan versus 6.25: $5496/201.51 =27.27 months.
Actually, the break even is likely to come a month or two earlier. But let's compute what happens if you refinance again into a 5% fixed rate loan for zero real cost right at breakeven time, 27 months. This makes the residual cost of the previous loan as low as reasonable.
The 6.25% loan leaves a balance of $263,241. When you refinance under this scenario, the new monthly interest charge will be $1096.84.
The 5.75% loan leaves a balance of $265,193. The new monthly interest charge will be $1104.97. The extra money on your balance costs you $8.13 per month, $100 per year. Plus you still owe almost $2000 more. Yes, you have technically broken even at this point because you saved that much in interest, but that benefit is gone into the past, while the extra money you owe and the costs of it are still with you.
The 5.25% loan leaves a balance of $267,104. The new monthly interest charges will be $1112.94. The extra money on your balance costs you $16.10 per month, $193 per year, from here on out. Plus you still owe almost $4000 more.
These are actually favorable assumptions compared to the real world in that they treat the 5.25% loan option much more kindly than it deserves compared to the 6.25% loan. Furthermore, the breakeven on buying a loan down is usually 3-5 years, a much longer period. Also, in this example I chose to wait to refinance until you had theoretically broken even, even though you didn't, really.
Most people have done this multiple times. $10 or $15 per month doesn't sound like a lot, but do it a couple times and you have $100 per month, and owing tens thousands of dollars more than if you'd gotten a cheaper loan that carried a slightly higher payment in the first place. I believe in offering choices, but I also know which I would recommend and choose for myself.
One point that needs to be made again is sometimes costs get built into the back end of a loan, via a pre-payment penalty. Most loan officers will not volunteer whether there is a pre-payment penalty, and many will lie even if you ask, just to get you to sign up, knowing that once you sign up you will likely consider yourself committed. This may not be legal, but it happens, and is another reason to read your loan paperwork carefully and shop several lenders. Reading the Note carefully at signing of final documents is the only way to be sure that there is no prepayment penalty.
The tradeoff between rate and cost is the most important fact of loans, and almost nobody pays attention to all the money they sink into the front end of a loan that they never get back via the lowered interest rate they bought with it. Instead, they refinance (or sell the home and buy another, requiring a new loan), and how they do this over and over again, adding thousands of dollars into their loan balance, needlessly and wastefully.
Caveat Emptor
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