Since a mortgage is basically a loan, borrowers instinctively feel that the interest rate on the loan is the primary factor that determines it’s price.
But comparing and deciding on a mortgage based on interest rates alone is the biggest mistake that borrowers can make these days.
Because with the way how mortgage costs are cleverly worked into modern home loans by lenders, there is much more about the actual price that most borrowers will eventually pay for.
It’s not that that the bulk of it is made up of hidden costs… I’ll leave you to determine that for yourself after reading this.
Here are the price components that add up the total cost of a mortgage.
1) Interest rate
Interest rate is the one feature that borrowers focus at. And understandably so.
This is the number, expressed as a percentage, that will be charged on the principal balance which will tabulate the interest due.
For FRMs, the interest due can be formulated for the life of the loan via a simple amortization table.
This is because the interest rate on a FRM is already set for it’s entire term.
White the quoted rate for a loan is an annual rate, it is applied monthly in calculation.
For example a $100,000 fixed rate mortgage at 6%, the monthly interest will be 0.005% (6%/12). This works out to $500 of interest per month.
Because of how easy and straight forward calculating interest for FRMs, it is much more simple to compare them when lined up against each other.
For ARMs, this interest due can change monthly because of the volatility of the variables that make up it’s interest rate.
Which leads us to the second component.
2) Index
For almost everything else other than a FRM, the mortgage is most certainly pegged to an index rate.
The types of loans that uses the value of indices are:
- Adjustable rate mortgage
- Hybrid mortgage
- Balloon
- etc
These types of housing loans have interest rates that consist of index rate plus a margin.
By summing up the two, we obtain the fully indexed rate, which is the actual interest rate that will be charged on the loan balance.
When such loans have a monthly adjustment interval, the mortgage payments will adjust accordingly after the loan has been recast. Resulting in different payment amounts for each month.
To protect borrowers from excessive volatility of index rates, lenders actually magnanimously include adjustment limitations on their loans so that borrowers will not wake up one morning and realize that they are going to default on their debts and face the very possible prospect of foreclosure.
However what people might no realize is that (maybe) part of the reason for this generosity is include a floor rate into the contract terms as well.
This floor rate is to protect them from losing money on their loans should indices makes movements that are unfavorable to them.
3) Points
Many people argue that points are expenses tied to the costs of credit and that lender are fair in charging them to borrower.
This line of thinking is also elaborated constantly to eliminate any objections borrowers raise regarding it.
Which is why it can be confusing when we see evidence of lenders and brokers reducing them for little apparent reason just to close a sale.
Points, expressed as a percentage of the loan amount, are essentially upfront charges.
They either require cash payment as part of settlement costs, or get added to the loan amount when financing points are requested by the borrower.
Points are closely related to interest rates because both are considered costs of credit items.
So it is common practice that points can be reduced should a borrower be willing to accept a higher interest rate. And vice-versa.
For example, a $150,000 mortgage at 5% and 2 points means that the borrower would have to pay $3,000 for points. However if he is willing to accept 6% interest, the lender might reduce the points to 1.
The logic is that they offset each other.
This give borrowers more choices on how to customize a loan into one which they can afford.
4) Rebates
Rebates are like freebies made of money that lenders can offer borrowers for concessions.
It can also come in the form of points.
For example, a borrower on a $100,000 mortgage at 5% with 1 point might get a 1.5 point rebate from the lender if he is willing to accept an interest rate of 6.5%. The rebate can then be used to offset the borrower’s final settlement costs.
This freebie is not a direct result of a broker becoming charitable. But most likely due to overage that will help them book in extra revenue.
Rebates are the one component of mortgage prices that you want as much as possible.
However, one would also have to keep a lookout for what he needs to compromise in order to accumulate them.
5) Origination
Mortgage origination is supposedly a lot of work… at least that’s what lenders and brokers constantly claim.
So tedious and strenuous is origination that originators charge a percentage of the loan amount as the origination fee.
This is puzzling as the amount of work should be the same no matter how big or small the loan size it.
Charging more for larger loans are like saying it takes much more work to increase the figures in an account to $100,000 than just $50,000.
If origination is a cost of credit, people might be able to comprehend why it has to be a percentage of the loan disbursed.
But it isn’t so. Which is why there is still reluctance of the general public to pay origination fees.
The reality is that origination fees are just points pretending to be something else.
Borrowers should make a mental note of this.
Sometimes, origination fees can actually make a loan seem more attractive than another.
For example, a loan with 2 points and 1% origination fees can appear more desirable than a loan with 2.75 points and zero origination fees. The truth is that the first one is actually more expensively priced than the second one.
Origination fees are typically tied to the par rate.
6) Third party and junk fees
These are cost items that are listed with dollar amounts rather than as a percentage of the loan.
Many of the services rendered are required for mortgages to close.
Such as:
However, many of such service providers are lender-controlled. Meaning they are appointed by the bank and the borrower has no say about whether to hire them or not.
This can sometimes lead to unreasonable premium fees charged by these service providers.
Another segment of service providers are third-parties.
These are not lender-controlled and the borrower has the authority to appoint who he is most comfortable with.
However, lenders might entice a borrower to hire someone they recommend by offering freebies like rebates.
Lawyers are the best example of them.
While you have the freedom to appoint an attorney of your choice, your decision is often already made because of rebates or subsidies that a lender would offer for using one of the law firms on their approved panel.
Junk fees round up the rest of the lot.
These are fees for whatever miscellaneous expenses that a lender incurs which they find fit to bill the borrower.
To many, these junk fees are considered ludicrous… and rightly so.
Especially when you find that they could include items like:
- Underwriting fee
- Processing fee
- Courier fee
- Application fee
- etc
Junk fees are like the sweets and chocolates we see at the cashier when queuing up to make payment at the supermarket.
It is like a final smash-and-grab tactic to squeeze as much out of a borrower as possible.
Maybe that’s why junk fees are often waived when borrowers negotiate hard enough for them.
Interest rate is not the only costs of a home loan
As you can see above, interest rate only makes up a small portion of the total mortgage costs.
Choosing between loans based solely on that one factor can cause self-inflicted consequences.
The popular argument is that interest rates will last for the entire life of the loan. So it eventually makes up the lion’s share of the costs.
That’s true… provided you hold onto the loan for the entirety of it’s lifespan.
In reality, very few home owners keep the same mortgage with them for life.
If a borrower takes up a mortgage with lower interest rates but higher points, it takes years before that trade-off starts to pay off.
Often times, the borrower refinances the loan before the break even point is even reached.
This is because points are upfront costs that borrowers pay in full. While interest rates are paid off little by little. Furthermore, we haven’t even factored in the other cost items other than points.
And there’s a very high probability that you would run into that scenario too.
It’s not unusual to find borrowers who take up a loan at 5% versus one at 8% and later discover that the former is more expensive due to it’s extravagant upfront charges.
Choosing a mortgage
When seeking a home loan, it is best that borrowers obtain quotes from at least 3 different lenders.
Or seek the services of a reputable broker as they are people most likely to find you the best deals you qualify for.
We discuss in-depth the details of mortgage shopping here.
While the APR has it’s limitations, it can give borrowers a good overview of the actual price of each loan. So make good use of it.
Finally, when a mortgage comes with slightly higher interest rates, don’t for a moment think that a 0.25% extra is like a drop in the ocean.
This is because when we factor in a large loan amount and the number of years ahead, this 0.25% will inevitably come up to thousands of dollars.
Possibly enough to take you on a world tour.