Trade Off Between Closing Costs & Mortgage Interest Rates

(April 10th, 2008)

You might be surprised to find out that your neighbour next door has a lower interest rate on his mortgage than you do, even though you bought your properties at about the same time. This has happened to thousands of Americans countrywide but we'll tell you why that is the case. Being so competitive, the mortgage market always has a tradeoff between loan closing costs & interest rates charged. Your neighbour who got the lower interest rate may have paid a lot more in closing costs than you did, and that's why he has a lower interest rate. What's more, a large portion of those closing costs may have been added to the loan balance, making it seem like he got a really good deal (because he did not have to pay cash for closing costs). So how can you balance the tradeoff between closing costs & interest rates making sure to pay the least in closing costs and getting the lowest interest rate possible? We will show you how to shop for mortgages and compare their real costs of borrowing.

i) Get Quotes from 3 Different Lenders

Taking out a mortgage might be the biggest financial decision you ever make. Therefore, shop around and collect mortgage quotes from atleast 3 different lenders. Compare the interest rate on the mortgage with a good faith estimate of closing costs including discount points. Lenders who offer very low cost mortgages have to make some money, and they will do so by charging higher interest rates. Most newly originated mortgages are sold to the secondary markets where higher interest rates are charged. Therefore, a lender who offers very low cost mortgages will have to sell his mortgages on the secondary market to make up for the discounts. A lender who charges higher closing costs may not have to sell his mortgages on the secondary market because he can still make money without charging higher interest rates. This is why the mortgage market is so competitive.

ii) Compare Costs Between Lenders

Mortgage costs vary by the type of mortgage, total amortization, from lender to lender and state to state. It can be very hard for the consumer to compare the costs because of the enormous complexities. One way to deal with this problem is to ask for a guarantee estimate of total closing costs, also known as a "good faith estimate." A good faith estimate can be requested in the shopping process, before you apply for the mortgage. Good faith estimate is therefore the first inquiry you will make to a mortgage lender, and it has no obligation (you are not obliging yourself to buy the mortgage at this stage). The lender will be more than willing to provide you with a good faith estimate because it is your initial inquiry and the lender does not want to refuse your business. Most lenders however will not be able to guarantee the good faith estimate because certain closing costs such as title insurance depend on third party insurance companies. The trick here is to make the lender guarantee on costs charged directly by him and not depending on third parties. Examples of closing costs included in the good faith estimate include:

Items to be paid when borrowing the loan

- Loan origination fees
- Loan discounts
- Appraisal fees
- Credit report fees
- Lender inspection fee
- Mortgage broker fee
- Underwriting, processing & wire transfer fees

Items to be Prepaid before borrowing the loan

- Mortgage insurance premium
- Hazard insurance premium

Title Charges

- Closing or Escrow fee
- Document preparation fees
- Notary & attorney fees
- Title insurance

iii) Compare Interest Rates

Any closing quotes you get from each lender has to be tied to a specific interest rate for a particular loan amount, and should also include discount points. The interest rate could fluctuate between the time you inquire about the loan and before you close, but the difference should be insignificant.

iv) Discount Points

Discount points are prepaid interest charges on a loan amount that is capitalized. They are expressed as a percentage of the loan. For example, one point might equal 1% of the mortgage loan, and the advantage is that it lowers the interest rate on the mortgage. Also, discount points are tax deductible.

Total Mortgage Balance

When closing, many borrowers do not factor in the closing costs that are added to the top of the mortgage balance. For example, a no-cost mortgage might not have any costs (although it will have a higher interest rate), while a no-cash mortgage will have closing costs, but these costs will be rolled into the total mortgage balance. This might slightly raise the monthly payment on your loan, but when amortized over 30 years, can significantly add to the total interest you will pay over those 30 years.