Many mortgage borrowers are tempted to finance their closing costs, that is, adding the costs to the loan amount. This could be attractive to borrowers who can earn high returns on their free cash, or those who don’t have any free cash. Financing closing costs is very costly, however, if the larger loan increases the price of the mortgage.
This will happen if the loan amount crosses a "pricing notch point" (PNP) — a point at which the interest rate, points or mortgage insurance premium increases. Since any price increase will apply to the entire loan, not just the increment used to finance closing costs, it will make the increment extremely costly.
For example, suppose financing $8,000 in closing costs on a $400,000 loan takes the loan past a PNP where the mortgage insurance premium jumps by 0.25 percent. The additional premium amounts to $1,020 in year one alone, of which $20 is on the $8,000 loan increase and $1,000 is on the original $400,000.
On conventional loans, PNPs in the ratio of loan amount to property value are 80 percent, 85 percent, 90 percent, 95 percent and 97 percent. As an example, if the $400,000 loan is 80-83 percent of value, adding closing costs of $8,000 to the loan won’t affect the price because the ratio will remain below 85 percent. But if the initial ratio was 84 percent, adding the $8,000 will bring the ratio above 85 percent, so the price of the loan will be higher. On FHAs, the only PNP at this writing is 95 percent.
The conventional loan amount also has a PNP at the largest loan that can be purchased by Fannie Mae and Freddie Mac, called the "conforming loan limit." Above the loan size maximum, the loan price will be higher. There used to be only one nationwide maximum, but now the maximums vary from county to county and range from $417,000 to $729,750. You can find the maximum for your county at http://www.ofheo.gov/media/hpi/AREA_LIST.pdf.
Don’t Wait to Pay Off a Collection Account
I am frequently asked whether, prior to applying for a mortgage, it is a good idea to pay off old collection accounts so they will no longer appear in the credit record. This turns out to be one of the trickier issues that arises in connection with credit scores, and I consulted with my credit guru, Catherine Coy, to make sure I had it right.
Borrowers should understand that paying off a collection account, like bringing a delinquent payment current, does not remove it from your credit record. As time passes, the impact on your credit score of an adverse item in the report gradually declines, because older information is less predictive of how good a credit risk you are than more recent information. But the adverse item does not disappear.
That’s why Catherine advises people who decide to pay old collection accounts to negotiate with the collection agency to get a "delete letter" sent to the credit reporting agencies. In effect, the letter states that it was all a mistake and the adverse item should be removed from the record.
When a borrower pays an old collection item, not only does the item not disappear, but the payment converts it into a current item, which increases its weight in the credit score. As a result, paying an old item, unless it is also deleted from the record, reduces the credit score!
The moral is very clear. The time to pay off old debts is well before you expect to be in the market for a mortgage. If you wait until just before you enter the market, the genii who scores credit will penalize you as one who disregards obligations until they need additional credit.
An Interest-Only Loan Cannot Pay Off Sooner
One of the most common myths that loan officers foist on prospective borrowers is that, if the borrower makes the same payment on an interest-only (IO) loan that he would make on the same loan without the IO option, the IO version will pay off sooner. This is nonsense. If the interest rate is the same on both, they will amortize in exactly the same way. And if the IO carries a higher rate, which is very likely, it will amortize more slowly rather than more rapidly.
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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