If you're shopping around for a home mortgage, watch out for loan quotes that carry seemingly low percentage rates, but tack on extras that can raise the true cost significantly.
With mortgage rates in most of the United States now stabilizing in the 11-1/2 to 12-1/2 percent range, sharp buyers who want to save money need to understand how points, placement fees, prepayment penalities and various other devices affect the real rate you pay for a loan.
Points, for example, are widely misunderstood and can put hundreds of dollars into a lender's pocket needlessly.
When one lender offers you a 12 percent loan with no points and another offers you an 11-1/2 percent loan with two points, which lender has the truly lower rate?
It could be the first lender, the one with the seemingly higher rate -- if you pay off your loan within the first eight to 10 years, as many borrowers do because of resale or refinancing. If you pay the loan off any time after 10 years, the 11-1/2 percent lender will prove to have offered the better rate. 1
Points are paid in cash up front, out of your pocket. A point is equal to one percent of the loan amount, and it's charged by the bank or S&L to improve its return on the loan. Points, in short, raise the effective interest rate paid by you, the borrower.
But by how much? It depends on how long you hold on to the loan. If you pay it off within a few years, every point can easily add more than half a percent to the rate you thought you signed up for.
Let's say that you get a $50,000 loan this month at a rate of 12 percent plus one point. The point will cost you $500 in cash at settlement, never to be refunded. Three years from now, you decide to move to a bigger house and pay off that 12 percent loan.
Figuring in the cost of that $500 you paid in cash, what was the effective rate on your 12 percent loan, exclusive of taxes? It turns out to have been close to 12-3/4 percent. That one point added 3/4 of a percent to your effective annual interest rate.
Even though the point was tax deductible the first year, you would have been smarter to have looked for any mortgage rate under 12-1/2 percent that was quoted with no points. You could have put your $500 to work earning interest elsewhere, rather than improving your lender's yield on your mortgage loan.
Let's say, however, that you hold onto your 12 percent loan until 1990 and then pay it off. By that time, the impact of the lump-sum $500 you gave the lender will have declined to 1/4 percent a year. If you hold on to the loan for still another 10 years, the rate impact will drop to about one-sixth of a percent per year. The longer the total period of interest payments, the smaller the significance of your original cash payment.
One point on a typical loan will add more than 1/4 percent on the effective annual rate of a loan paid off in less than eight years. If there's a chance you'll buy again or refinance within eight years, keep this in mind.
Here are some other mortgage extras that savvy consumers should watch for in 1980:
Servicing fees, placement fees or standby fees of one point or more are used by some lenders as the functional equivalent of higher interest rates. Unlike regular loan points, though, they aren't deductible on your federal tax returns because they're not considered interest. They can add 1/2 percent or more to the effective rate of your mortgage.
Prepayment penalties are one of those "boiler plate" extras that slip by many consumers without notice. A loan that carries language requiring you to hand over a one-point penalty on any payoff during the first five years can cost you $500 to $1,000 -- and add significantly to your effective rate.
Some states limit or ban prepayment penalties, but others allow lenders free rein. Such penalties can be big profit producers for lenders in transient high-mobility areas of the country. Ask about these fees at every S&L, bank or mortgage broker firm when you comparison shop. The lender with a 12 percent rate, no points and no prepayment penalties may be cheaper than the one with that enticing 11 percent rate.
Renegotiable rate, three- to five-year mortgages out to carry lower effective rates than longer-term loans. If you're comparing a loan whose rate theoretically could be increased on you sometime in the future, it ought to have a lower starting rate than 25- or 30-year conventional loans available from other lenders.
That's because long-term rates include an inflation factor for the protection of the lender. With a three- to five-year loan, the lender can adjust for inflation periodically -- and should therefore charge you at least one percent less at the beginning.