Evaluating Home Loan Interest Rates and Closing Costs

When considering the interest rate associated with your home loan, it is important to understand that once qualified for a particular home loan program, more often than not, you will have a variety of interest rates available to you to choose from. This fact is something that most people never realize, and can turn into a costly mistake. The purpose of this article is to breakdown home loan interest rates for consumers to understand the difference between their rate and the price associated with their home loan. With this fundamental understanding you will be able to evaluate the interest rate and closing costs associated with a proposed home loan in conjunction with your personal plans for the sole purpose of determining the benefits of a proposed home loan.
Once qualified for a home loan you will have a wide variety of rates available to you. Usually this point remains undisclosed to the consumer; regardless this remains a truth in nearly all situations. Of all the interest rates offered to you, one will be deemed your "par" interest rate. Par in the mortgage industry is a term used to describe the interest rate closest to coming at no cost and paying no yield spread. For this reason you can think of par as your neutral interest rate.
Every interest rate that is offered to you is going to have a charge associated with it, with the par rate separating the charge into two forms either positive or negative. If the charge is positive, the interest rate comes at a cost, if however the charge is negative that interest rate is above market and is paying back a yield spread to the originating agent outside of closing. Yield spread premium is also known as "rebate" or "YSP." If the rate pays enough rebate, a no cost home loan can be accomplished. Whether this is the best option is something that should be evaluated.

Rate 4.875% 5.000% 5.125% 5.250% 5.375% 5.500% 5.625% 5.750%
Base Points 0.875% 0.125% -0.375% -0.625% -1.000% -1.375% -1.750% -2.000%
Lock Period 0.125% 0.125% 0.125% 0.125% 0.125% 0.125% 0.125% 0.125%
AdverseMarket 0.250% 0.250% 0.250% 0.250% 0.250% 0.250% 0.250% 0.250%
Special -0.250% -0.250% -0.250% -0.250% -0.250% -0.250% -0.250% -0.250%
FINAL 1.000% .250% -.250% -.500% -.875% -1.250% -1.625% -1.75%

Here we have an example of an internal rate sheet that is usually not shared with the public. Across the top you will see a variety of interest rates offered which change throughout the day based on market fluctuation. These are all the interest rates available to you at this particular time. As the secondary market (which is where mortgage notes are bought and sold by major lending institutions and where the interest rates are established) moves up or down these offered rates will move accordingly, but not as one might expect. What forces rates to go up or down are pricing adjustments. The first adjustment know as "base points" is what fluctuates based on market trading. With enough volatility the base price will adjust thereby changing your par rate for better or worse... a point I make becuase rates are always available, how much you will pay for any given rate is what changes.
Below the interest rates published and their base points are pricing adjustments that are particular to this situation (your pricing adjustments may be better or worse than those represented in this example). These adjustments will remain static for all interest rates as long as the loan parameters do not change.
The final catagory at the bottom labeled "FINAL" is the total of the price adjusters and the final cost or rebate of the interest rate published. Notice that the lower rates have a higher cost while the higher interest rates pay rebate back to the originating agent. In this particular example your par interest rate falls between 5.000% and 5.125% because 5.000% comes at a slight cost of .25, and 5.125% pays a small rebate of -.25.
So what do does FINAL mean to you in dollars and cents? Multiply this FINAL figure by your loan amount and you will know how much that rate will cost you up front, or how much that rate is paying back in yield spread to your loan officer. For example on a 200,000 dollar home loan at a rate of 4.875% would mean a cost of 1.000%, or 2,000 dollar up front for that particular rate. Let's add another point for the originating agents fee for service which is another 2,000 for a total cost of 4,000 dollars. In this example it is important to understand that one point is going to buy down the interest rate, the other point is what the originating agent hopes to make on the transaction. If you didn't want to pay these fees up front, you could accept a slightly higher rate, let's say 5.500% which is paying a rebate of -1.25%... this rebate will result in 2500 dollars being paid back to the originating agent for selling you a higher interest rate than the market is offering you. By taking this higher rate essentially you have created a situation in which the lender is paying the originating agent his compensation thereby avoiding the higher closing costs associated with the lower rate.
To continue, a home loan for 200,000 dollars with an interest rate of 4.875% has a monthly payment of 1,058.42, while that same loan amount with a rate of 5.500% has a payment of 1,135.57 (both amortized). The monthly difference equals 77.15 a month. Over 30 years or 360 payments you will spend 27,774 more by accepting the higher interest rate. The gross difference in cost between these two rates is 6,500 (4000 + 2500) which is clearly made up in savings over the course of the loan. Bottom line, the lower interest rate with higher closing costs, costs less over the course of the loan, than the higher rate with lower closing costs.
So how do you use this information to evaulate your personal situation? By understanding how your interest rate is determined and the costs associated with each individual rate offered, you will be able to plan accordingly. If you will be selling your home in a short period of time, the no cost loan may make more sense, in our example above it will take 85 months to make up the 6500 dollar cost spread between the rates used in our example above. So if you will be selling your home inside of 85 months, it would not make sense to take the lower rate and higher costs. On the other hand if you plan on keeping your home for a long period of time the best course of action would be accepting the lower interest rate and the higher cost because the monthly savings would eventually make it worthwhile... when... 85 months later or in 7 years. Or course it may make sense accepting a rate somewhere in the middle of of this spread; the point is these options are rarely explored to their full degree, and doing so is an exercise well worth the time because it allows you to tailor the cost of closing to your particular situation.
Evaluating which interest rate has the most benefit for you is something your loan consultant should be willing to help you with. With that said it should be mentioned that this is not always the case, moreover certain lending institutions, namely those carrying CFL licenses are not required to disclose yield spread/rebate that is collected at closing, so if you are not working with a lender that is entirely forthcoming, you may not be aware of some of these options. Moreover the lender could choose to simply keep the entire yield spread and charge an upfront fee for service costing you significantly more than is required to close the loan elsewhere.
For this exclusive reason it is important that the lender you choose to work with is willing to provide you full disclosure of the fees you are being charged. Usually this means agreeing on a set fee for service that the loan officer will be making before moving forward. Once this is determined, how the fee for service is made becomes irrelevant, and full disclosure of the yield spread and fees assoicated with the rates can be discussed in full confidence.
At the time you lock your rate with the lender, your lender should be able to demonstrate on the lock confirmation the yield spread or up front cost of the associated interest rate, and the remaining fees can be adjusted if necessary. The rate lock confirmation is something most consumers never ask for, but it is a very useful document to have and I highly recommend you request one from your lender as soon as your home loan is locked. It should not be a problem for your loan consultant to provide, and if it is that may be a sign something is wrong.
By taking action, you will play an active rather than passive role in determining the cost of closing for your new home loan. This will help ensure that your future goals are met and the home loan in contributuing to your overall plans rather than standing in as an obstacle. Because most people's home loan is their largest form of debt, it is crucial that terms be in line with their future plans, and this is one of the most effective forms of evaluation.
We are committed to servicing our clients, and hope you have found this information helpful. For more information please feel free to contact us directly so we can assist you on a personal level.