People buying or refinancing typically assume that getting a low rate mortgage is an indication that they got a “great deal”. You may be surprised to hear that most of them are probably wrong.
Whether it’s a result of the media, family and friends or mortgage lenders themselves, consumers have been trained to look for the lowest interest rate. To a degree, that makes sense since a lower interest rate means a lower monthly payment. Over the life of a 30 year loan, knocking an extra .125% off the rate can mean thousand of dollars in savings. The problem is that few buyers will ever keep a loan long enough to realize any savings.
When it comes to mortgage loans, there is a general rule that applies: Lower interest rates have higher closing costs while higher rates have lower costs. Specific rates and fees may vary from company to company but the basic rule applies to everyone.
Let’s compare two loans at $200,000, one with a lower rate and higher fees and the other with a higher rate but lower closing costs and see which option is really more attractive.
Buyer #1 chose to pay a traditional 1% origination fee ($2,000) to get a rate of 4.5%. Their principal and interest payment (P&I) will be $1013. Buyer #2 decided to pay 4.75% in exchange for having no origination fee. Their P&I payment would be $1,043 per month.
While it is true that Buyer #2 is paying an extra $30 per month, they saved $2,000 right from the start. It will take 5 ½ years of paying $30 each month before they pay out the $2,000 they’ve already saved. Statistics show that about half of all mortgages are paid off in less than five years. Buyer #2 will likely sell their home or refinance before they ever pay out the $2,000 they saved up front. But that is just the start!
If Buyer #2 chose to take the $2,000 they saved in fees and paid it towards their principal balances, they would lower their loan amount to $198,000 and their payment to $1032. That’s still about $20 higher than Buyer #1 but they owe $2,000 less on their home. Buyer #2 would need to pay that $20 for over eight years before they pay out the $2,000 they saved up front. But the savings don’t stop there!
In most cases, the closing costs that are paid at closing are not tax deductible while the monthly interest usually is. A buyer paying a higher interest rate will also enjoy a larger tax deduction. Let’s assume Buyer #2 pays an average tax rate of 20%. If they are paying an extra $20 per month in interest, they will save $4 of that back by reducing their tax liability. The true cost of their interest now drops from $20 to $16 per month. They would need to pay the extra $16 per month for over 10 years before they pay out the $2,000 they saved right from the start by going with the higher rate!
Each borrower needs to look at all their options when taking out a mortgage. The key is finding a mortgage consultant that can help analyze their needs and give them accurate and useful advice. Most would be better served shopping for the best, most knowledgeable lender rather than for the lowest rate. In the long run, they may save a lot of money.