Home Loan & Mortgage Price vs. Cost Analysis

When evaluating a proposed home loan, the first thing that must be done is differeniate the "price" of the home loan from the "cost" of the home loan. The price of something is how much you pay for it initially, while the cost of that same item is how much you spend over time for that item to remain operational. When considering a home loan, it is clear that there are two very different types of expenses - closing costs and your monthly mortgage payments. In the mortgage industry these are known as reoccuring (cost) and non-reoccurring (price) closing costs.The reoccurring costs refer to the closing costs that will be collected in escrow when finalizing the loan. Due to the various ways home loans and the associated fees can be structured, and as a means of evaluating different programs between one another, our government requires the disclosure of a representative number that consolidates the total cost of the loan weighted proportionally, and represents it in a single rate known as your Annual Percentage Rate or APR which can be found on your Truth In Lending.

Regardless the APR is not a final measurement, and this type of evaluation requires a more in depth analysis. There are four primary points that must be considerd when considering price vs. cost anaylsis: the interest rate, the cost of closing, the term, the loan program.

The type of program that is in question is very important because different programs are going to produce different figures, therefore it is important to compare "like" porgrams when evaluating price vs. cost. Comparing two different programs is going to make this type of evaluation subjective by introducing risk and security. In addition the program you are applying for will have internal guidelines, so if you decide to change the terms of the loan (how much you are borrowing, cash out or rate and term, primary residence or investment property, credit score, etc...) but want the same program, you may inadvertantly change the terms offered for that program so do you best to avoid this type of situation when possible. The point is differences do exist inside of a single program, therefore accuracy is crucial during your evaluation.

The term is the most expensive part of a home loan which is why it is an independent point. It is the largest contributor to cost. Extending the term guarantees a higher cost because you will be required to make more payments. A 200,000 dollar loan fixed for 30 years at 5% interest has a payment of 1,073.65; over 30 years or 360 payments you will have spent 386,514. A 200,000 dollar loan fized for 40 years at 4% interest (one full point lower) has a payment of 835.88; over 40 years or 480 payments you will have spent 401,222. Despite the lower interst rate and payment you will have spent 14,708 more due to the term. Accepting the shortest term possible will reduce your cost significantly, moreover interest rates are, more often than not, better for home loans with shorter terms (less risk to the lender) so you get the best of both worlds.

The interest rate is going to have a large effect on your cost, after all the lower the interest rate the lower the monthly payment associated with your home loan. It goes without saying you want to get the lowest rate possible, so you have two choices wait for a lower offered interest rate, or buy the interest rate you want. The first option is what most people elect to do, unfortunately they are operating on hope rather than fact that the market will move in the right direction in the timeframe they require. If this is your plan it is important that you are paired up with a professional that keeps a close track of the market you will be participating in (there are different markets the largest being the Mortgage Backed Securities or MBS). If this is your plan and you do not have a loan consultant you trust that actively watches these markets and knows your future plans and when to contact you, and you are relying on your local newspaper, random internet searches, or the network news, it is highly recommended you seek professional help immediately and find a home loan consultant that watches these markets and is focused on your goals rather than an immedaite commission. If on the other hand you are already in a position in which you must close and buying the rate down is an appealing option you must take a close look at the cost of closing.

The cost of closing is going to include all of the upfront fees required to close the loan. These fees will include third party title, escrow and recording fees, interest per day, impounds (if you are going to have impounds), lender fees, cost of the interest rate, loan origination fee to your loan officer (if this applies they could make it in yield spread/rebate), the appraisal fee, etc.... There are different ways to handle the cost of closing, bringing cash to the table, paying with current equity, seller credits, broker credits, are a combination of these.

If you bring cash to the table, the primary advantage is keeping your home loan balance low, after all the lower the balance the less interest collected. If you choose to settle closing costs with equity essentially you are financing your closing costs... after all your loan balance will be higher and you will be paying interest on that additional portion borrowed. If you are highly concerned with cost (long term expenses) and motivated to reduce your principle balances as quickly as possible, the first option listed here would make the most sense for you because it is taking advantage of the true "price" concept. For most people however, financing the cost of closing into your home loan is a reasonable compromise and the ultimate direction they go. This solution does demonstrate a concern over cost, but is not as conservative as paying the cost of closing out of pocket to keep the loan balance low. With that said it is definitely more conservative than accepting a higher interest rate and taking a no cost loan.

The question remains, what if your plans are not long term, and you are more concerned over the price than the long term cost? This is when you look into a no cost loan. A no cost loan is accomplished by you accepting an interest rate that is above the current market rate. The yield spread generated by the oversold interest rate can then be credited back to be used to cover the cost of closing. Instead of the closing costs being added to your loan amount, they are made in commission, and then credited back to cover the cost of closing. The clear disadvantage of this is because you are accepting a higher interest rate your monthly payment will go up. If you know you will be selling or refinancing your home in the near future this is a better option because a no cost loan has the lowest price, but the highest cost associated with it. It actually should be called a "no price loan."

Here is an example that demonstrates the price cost relationship for a rate and term refinance (program) covering a 195,000 dollar home loan currently at 7% interest with a payment of 1,330.60 set to adjust up to 8% next month on their primary residence (program). The client wants a 30 year fixed (program/term) and to know their options:

So we know the general program - rate and term refinance, primary residence, and a fixed rate. We also know the preferred term, 30 years. Closing costs are going to be 4,000 dollars all inclusive, and clearly this is something the client needs to move on because of their currently high and adjusting interest rate. The proposed interest rate with these closing costs is 4.875%. If you were to elect to pay the closing costs out of pocket your loan amount would remain the same, 195,000. At a rate of 4.875% the principle and interest payment on this loan amount would be 1,031.96. If on the other hand you elected to wrap the closing costs up into the loan you would have a new loan amount of 199,000 at a rate of 4.875% with a payment of 1,053.15. The advantage of not spending 4,000 dollars out of pocket on closing costs is clear, you retain the liquid 4,000 dollars which you can invest in other markets. the disadvantage is a higher payment of 21.19. It would take 189 months or about fifteen and a half years to make up this difference which is why most people elect to wrap the cost of closing into the new loan. For most, the chances of moving or refinancing within fifteen years is substantial so the out of pocket up front cost of 4,000 to close would not be cost effective. Then again if you plan on trying to pay down your balance quickly, or will be holding onto this loan throughout the duration; paying the fees out of pocket will save you money, demonstrated by the numbers above.

Both of these options represent high price but low overall cost home loans. If we went the other direction we could drastically reduce the price, but the cost would increase. If this client decided to accept a higher interest rate than the market offered say 5.875% that rate would pay the originating agent a yield spread, which the agent (if willing) may credit back towards closing thereby achieving a no cost loan. 5.875% pays a rebate of 2.125% which means the originating agent would make 4143.75 in yield spread off of a 195,000 dollar loan. The associated payment would be 1153.49 which is 100.34 dollars higher than the same loan with closing costs wrapped into the new loan balance of 199,000 (above). It would take 40 months before the higher payments cost you more than the closing costs associated with the lower rate (4000.00 dollars), so if you were planning on selling or refinancing inside this time period, the no cost loan would make more sense than the low cost loan it is compared to.

These calculations can be made and applied to any type of home loan. By evaluating this price cost relationship inside the program you are looking to take advantage of, you can identify the best fee structure based on your particular situation, which does not always transpire into the lowest APR (Annual Percentage Rate), which is why you cannot look to this figure as the final determining factor. A no cost loan will have a higher APR than a low cost loan because of the difference in interest rtes, but if your plans warrant a no cost home loan, the higher APR should not concern you. If on the other hand you are looking for long term financing that will stand the test of time, securing the lowest possible APR should be a primary focus.

Generally speaking a low cost loan with fees wrapped into the new home loan will cost you far less then any no cost loan. In our above example 199,000 dollar loan at 4.875% had a monthly payment of 1,053.15 while the no cost loan although smaller (195,000) had a payment of 1153.49. Over 30 years the low cost loan will cost you 379,134 (1053.15X360), while the no cost loan would cost you 415,256.40 (1153.49X360). The conclusion we can draw, paying a higher price will mean spending less in cost over the couse of the loan. Cost is always more expensive than price, and should be taken advantage of only in specific situations that require short term solutions.

Whatever your sitaution, if you are working with an experienced loan officer that understands the details and consequences - good or bad - of price cost structure, you should be able to work through your particular situation and identify the most advantageous solution based on your future goals.

We are committed to servciing our clients and assisting them in evaluating the fee strucutre of all loans recommended. For your own detailed free evaluation froma professional with no oligation please feel free to contact us.