Must-knows about mortgage rate/fee combos

Don't assume loan officer has your best interest in mind

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Editor’s note: This is the second of a two-part series.

Last week I discussed a new integrated calculator on my website that uses current and personalized mortgage price data to help borrowers select the type of mortgage that would minimize their net costs. This article introduces a second integrated calculator that helps borrowers select the best combination of interest rate and lender fees on their preferred type of mortgage.

Before describing this new approach, it is instructive to consider how the rate/fee combination is selected now.

Lowest rate used to solicit naive borrowers

Naive borrowers know that mortgages carry an interest rate, but they don’t know that the rate varies with the amount of total upfront fees. They are thus vulnerable to solicitation from lenders and lead generation Internet sites promising the lowest rate.

While the lowest rate carries the highest fees, the fees are not disclosed. The annual percentage rate (APR) must be disclosed, and will be much higher than the lowest rate, but because these borrowers usually don’t know what the APR is, they often ignore it.

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Borrowers who respond to the solicitation and start the process will soon be confronted with the bad news about the fees required. At that point they may flee, or they may allow themselves to be sold another rate/fee combination by the loan originator (LO) — a loan officer or mortgage broker.

Loan originators look for an acceptable combination

Most LOs try to guide the borrower toward a rate/fee combination that is responsive to the borrower’s major weakness. If the borrower is cash-short, the LO will steer the deal toward a higher rate which may carry a cash rebate from the lender, for example.

If the borrower’s problem is income adequacy, the LO will propose a lower rate that carries a lower monthly payment. The combination selected must meet underwriting requirements and be acceptable to the borrower.

What LOs seldom consider are the implications for the borrower’s future wealth, which depend on the total cost of the combination selected over the period the borrower has the mortgage. Information on future costs has never been available before.

The integrated rate/fee calculator

In last week’s article, I used the integrated type of mortgage calculator to compare a 30-year fixed-rate mortgage (FRM) and a 5/1 adjustable-rate mortgage (ARM) on which the initial rate held for five years and was adjusted annually thereafter.

In step two of the decision process, I assume the borrower selected the 5/1 ARM, and now must select the combination of interest rate and total upfront fees on this ARM from those available. The table below shows the available combinations and the total cost of each combination over different periods selected by the user.

Interest Rate/Fee Combinations on 5/1 ARM of $270,000
 Dec. 8, 2011

Interest Rate

Points and Other Fees Paid in Cash Upfront

Initial Monthly Payment

Total Net Cost Over Assumed Life of Loan

3 Years

5 Years

8 Years

1.75%

$11,819

$965

$20,537

$28,459

$47,698*

1.875%

$10,780

$981

$20,469

$28,848

$48,118

2.00%

$9,743

$998

$20,403

$29,241

$48,544

2.125%

$8,714

$1,015

$20,345

$29,645

$48,980

2.25%

$5,392

$1,032

$18,517

$28,226*

$47,510*

2.375%

$4,423

$1,049

$18,507

$28,683*

$48,001

2.50%

$3,724

$1,067

$18,711

$29,361

$48,724

2.625%

$3,133

$1,084

$19,000

$30,129

$49,541

2.75%

$1,976

$1,102

$18,821

$30,416

$49,855

2.875%

-$11

$1,120

$17,672*

$29,705

$49,125

3.00%

-$465

$1,138

$17,953*

$30,470

$49,938

3.125%

-$704

$1,157

$18,459

$31,469

$50,995

3.25%

-$724

$1,175

$19,196

$32,707

$52,303

*Denotes the two lowest-cost combinations. The components of total cost are shown in last week’s article.

Using the calculator

The best way to use the integrated calculator depends on the borrower’s major concern. Borrowers who can deal with the highest monthly payment and the largest upfront fees shown in the table should select the rate/fee combination with the lowest total cost over the period they expect to have the mortgage.

As that period lengthens, the advantage shifts toward lower rates and larger fees, because the benefit of the lower rate extends over a longer period. I have flagged that tendency by placing asterisks next to the two lowest-cost combinations for each period.

If the borrower’s major concern is cash, he excludes the top part of the table and looks for the lowest cost from the rate/fee combinations that remain. If the borrower’s major concern is the initial payment, he excludes the bottom part of the table, selecting from the combinations that remain.

Some borrowers may want to impose both a cash and a payment limit. For example, the borrower represented in the table might want to cap cash outlays at $9,000 and monthly payment at $1,100. In that case, there are only five rate/fee combinations from which to choose. But that is four more options than he is likely to have without the calculator.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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