Is a loan with no fees or origination charge the best deal? Maybe. Never forget that interest rate is only half of the equation. Rate AND fees are the whole equation upon which you should make a decision. When talking to borrowers who have been shopping rates, I always ask the same questions. What is the term of the mortgage, are both mortgages fixed rate, and what costs are associated with the mortgage. Sometimes a borrower is comparing a 10 year fixed rate mortgage to a 30 year fixed rate mortgage. We need to make sure we are comparing apples to apples. The longer the term of a fixed rate mortgage, the higher the rate. It is very common when I inquire about the exact dollar amount of the closing costs or fees associated with the mortgage, the borrower does not know the answer because they either were fixated on the rate or it was not properly disclosed.
Fees to obtain a mortgage are referred to as closing costs. Closing costs are defined as all costs associated with a borrower obtaining a mortgage. These costs include, but are not limited to, origination fee, discount points, appraisal, title insurance, flood cert, doc prep, processing, etc. Prepays are charges for property insurance and funds put into the escrow account for property taxes, insurance, etc. Borrowers should always be careful to make sure that they are looking at a true no fee loan, and not one where the closing costs are added to the loan amount. On a true no cost mortgage, except when there is mortgage insurance or a VA funding fee, the interest rate should match the annual percentage rate (APR) as disclosed on the Truth-In-Lending disclosure statement (TIL). If mortgage insurance or a VA funding fee is required, the APR will be higher than the note.
Analyzing the mortgage choices to see what is best for the borrower is simple. Look at the difference between the costs associated with a mortgage and examine how long it will take you to break even. For example, lets compare two thirty year fixed rate mortgages with a mortgage amount of $300,000. One mortgage has a 4.25% interest rate and $6,000 in closing costs and the other option is 4.75% with no closing costs. Principal and interest for the 4.25% mortgage is $1,476 and $1,566 at 4.75%. By dividing the difference of $90 per month into the $6,000 for closing costs, we see that it will take the borrower 67 months to break even. This simplified analysis does not take into account the possible income tax ramifications or the time value of money.
Another important thing to consider is if the money used for closing costs could be better utilized paying off credit cards, kept for liquidity, used to fund a retirement account, etc. A borrower does not want to be equity rich and cash poor. As I know personally, it is very hard to eat equity. Borrowers should always remember to look at the whole forest, and not just one tree. I have noticed mortgage professionals almost always do their personal mortgage on a no cost basis. As always, the answer is to do the numbers and see what is best for your personal situation.
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