For most borrowers, the cost of mortgage financing -- and the lender's income--can be measured in terms of interest. But interest is only one mortgage expense. There are others, and they can greatly influence the cost of financing.
Mortgage rates are described by both a nominal rate, say 12 7/8 percent, and the APR, or annual percentage rate, a figure which is generally higher than the nominal interest cost, perhaps 13.96 percent in this case. The difference between the nominal and APR figures is the result of interest compounding. For the purposes of comparison, the APR figures always should be used.
In a growing number of situations, however, it is difficult to cite a specific interest cost. With some variable-rate mortgages, for example, there may be an attractive interest rate initially, but it is subject to change. Rate fluctuations over the life of a variable-rate loan are not predictable, and so determining a set APR is not possible.
There are many situations where borrowers select one lender over another on the basis of interest rates. While it certainly pays to shop for interest rates, other expenses should not be ignored. Consider these costs:
Fees. Many lenders charge to process loan applications, and these costs vary. Ask if all or part of the fee will be refunded if a lender does not provide financing.
Reserves. Different lenders require different reserves, that is, money held by the lender to assure the payment of property taxes, condo fees or mortgage insurance premiums. Reserves can be a major cash drain at settlement, so be certain to compare lender practices in this area.
Points. A point is a fee equal to one percent of the value of a mortgage. Various points are paid or credited to the lender at settlement. If you buy a $100,000 house and get an $80,000 mortgage, one point would be equal to $800.
Points are important because they can raise interest costs significantly. Over a period of 30 years, a single point will add approximately one-eighth percentage point to the mortgage rate. The catch is this: Few mortgages last 30 years. The U.S. League of Savings Institutions estimates that the average mortgage has a term of 11 1/2 years. Suddenly one point is likely to add more like three-eights of a percentage point. Buyers should be aware that the number of points charged varies, so it frequently pays to shop the market for the best terms.
Because points are a one-time expense, they are proportionately more expensive for brief loans than for long ones. This means that, in some situations, a higher rate of interest actually costs less than a lower rate with points.
Borrowers need to calculate the actual cost of various combinations of points and interest. In most cases, deciding whether to opt for a higher interest rate or more points--when such options are available--is a function of time. The longer a property is held, the less the cost of points.
Suppose there is a choice of a 30-year, $100,000 loan at 12 percent interest plus two points, or a similar mortgage with a higher interest rate, 12.375 percent, but only one point. What are the economics of each choice?
The first loan will require a $2,000 payment or credit to the lender at settlement. The monthly mortgage payments will be $1028.61. For the loan with the greater rate of interest, the cost at settlement will be one point, or $1,000, and monthly mortgage costs will be $1057.57--$28.95 a month more interest but $1,000 less at settlement.
If the property is going to be held for more than three years, the loan with more points is a better deal. The reason is that, after three years, the cost of interest associated with the high-rate, low-point mortgage will exceed $1,000. This means that personal planning, such as a contemplated job change to another city in a few years or early retirement, may dictate which loan is the bargain.
Another important factor in the financing package is offsetting costs. Financing expenses can drop rapidly when they are paid by the seller instead of the borrower. The cost of points is commonly split and, by negotiation, other costs can be assigned to the seller.
For lenders, items such as points and fees are a welcome addition to interest. In total, they provide the actual yield from a given loan and, to borrowers, the true cost. The use of points and fees to enhance a lender's yield should not be regarded as evil or unfair. Lenders have a right to protect and promote their economic interests. Borrowers do, too, and for this reason it pays to shop for mortgages and compare all costs