Excerpt from What Consumers Need to Know About Mortgages

Sorry this is late. There was some behind the scenes drama; the server the website was hosted on had a crash and the website had to be migrated and for boring technical reasons I couldn't log in to some functions for a while.

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It's quite fashionable in some quarters to brag about the low interest rate of your home loan. One question every good loan officer hates is "What is your lowest rate?" usually the first thing in a phone conversation. People think that this sort of rate shopping is going to help them. The fact is that it almost ensures they are going to get ripped off or worse, as millions of people have discovered in the last few years - and most of them don't understand that this attitude is precisely what got them into the toxic loan that ruined them financially.

First off, everybody doesn't get the same choices. As I've said before, somebody who can prove they make enough money, has a solid history of paying their debts, and offers the lender a situation where there's 30 percent equity (or more) gets a different set of choices than somebody who can't prove they make enough money, has a questionable history of paying debt, and wants to borrow 100 percent of the property value (or more).

Second, different loans get different rate-cost tradeoffs. The loan that most people seem to consider the most attractive loan, the thirty year fixed rate loan, is always the most expensive loan out there with the highest rate/cost tradeoff. Why? Because on top of the cost of the money, you are essentially purchasing an insurance policy that says your rate will not change for thirty years. Even when long and short term rates are inverted there is a premium charged for the thirty year fixed rate loan. It makes a certain amount of sense; insurance policies are never free, and the thirty year fixed rate loan is the most desired loan out there. Simple economics: Higher demand equals higher price. Goods perceived as more valuable carry a higher price tag. So if you're looking for a thirty year fixed rate loan, and all you say is "What is your lowest rate?" you are likely to get quoted a rate attached to some other sort of loan, or even a phantom, 'in name only' rate that isn't the real rate you're actually paying interest on. Even today with negative amortization loans gone, there are replacements which may not be quite so toxic, but are certainly nothing you actually want to be signing a contract for. There is a tradeoff between types of loans, where you pay for more features with a higher interest rate. To get thirty years of insurance that your rate and payment won't change, you must pay the highest interest rate. If you want to argue with me, consider the meltdown we've been having these last several years caused by toxic loans. If interest rate (or worse, payment) is your only data point from the various loan providers you talk with, you are likely to do business with the one who quotes you the negative amortization loan, not the thirty year fixed rate loan. Matter of fact, the loan provider who tells you about the loan that you really wanted is least likely to get your business in this scenario, because you're ignoring the important context of the tradeoffs involved.

Third and most importantly, for every situation and every loan type, there is more than one rate available, a set of tradeoffs within the same type of loan. Why is this, you ask? It seems obvious to you: Why not just choose the lowest rate, which has the lowest payment? It takes a little examination to see why.

The difference between the rates is in cost of the loan. There will be a rate called par. This is the rate at which the lender will loan you the money straight across. They don't charge you any money (discount points) to get a lower rate. They don't pay any of the costs of the loan. Getting a loan done really does take a minimum of about $3300 in closing costs (actually, that figure is for California, which believe it or not is one of the cheaper states to get everything done in - every other state I've done business in has higher closing costs), plus whatever the lender makes in order to do your loan. Whether points and closing costs are paid out of your pocket or added to your mortgage balance, you are still paying them. Indeed, when shopping for a mortgage, the phrase "nothing out of your pocket" from a prospective loan provider should immediately put you on guard. I explained at the end of the last chapter some of the legal fiction about why it's not always bad, but it should put you on guard. It needs at least one of two further phrases, "and nothing added to your mortgage," or "no costs at all," before it really means you aren't paying thousands of dollars. Why? Because loan officers have learned to sell loans based upon the cash that people have to pay, which is not the same thing as the actual cost. I've had people tell me they didn't pay anything for a refinance, when they had over twenty thousand dollars added to their mortgage balance. That money is every bit as real as cash out of their wallet or checking account. The only difference is they're pretending you're not paying it despite the fact that you are. Don't know about you, but I'm a lot more kindly disposed towards the person who tells me something is going to cost ten thousand dollars when that's what it costs, than I am towards the person who pretends it's not going to cost anything despite knowing full well it's going to cost ten thousand dollars.

Getting a lower rate (assuming it's for the same type of loan) costs more money in terms of upfront costs. In all the years I've been reading rate sheets, I have never once seen an exception to this, from any lender. It's firmly grounded in the laws of economics. For rates below par, you must pay discount points. This is an upfront incentive to a lender to give you a rate lower than they otherwise would. Every situation is different and should be analyzed with numbers specific to that situation, but as a rule of thumb: Unless you're getting a thirty year fixed rate loan and you have a history of keeping loans at least five years before sale or refinance, you should avoid paying discount points if you can, and accepting a rate with a bit of yield spread to offset origination is probably a good idea. The lower payments you get, quite simply, are usually not worth the cost of adding points to your mortgage balance. People who don't qualify for 'A paper' may not have this option, but more people qualify 'A paper' than think they do. These days, with true subprime essentially extinct, it's 'A paper', what professionals used to call "A minus" which is essentially for people who barely miss qualifying A paper, or you fall all the way to 'hard money' - and that's if you have the equity. Otherwise you get nothing.

The money you pay for a rate lower than par can be paid out of your loan balance, or it can be paid with cash out of your pocket, but it will be paid if you want that rate. If you keep the loan long enough, the lower rate will pay for itself, but those costs for the lower rate are an upfront cost and sunk into the loan whether you keep it long enough to break even or not.

If you were to spend (for example) seven thousand dollars on an investment that only returned four thousand dollars before you sold it, most people would have no trouble seeing that it was a bad investment that lost money, but they have a much harder time seeing this with seven thousand dollars added to the balance of their loan that only returns four thousand dollars in lowered interest charges before they voluntarily refinance. When you refinance (or sell), the benefits to that previous loan stop. The lowered interest rate you bought for those dollars is gone, and is irrelevant going forward. But if you rolled the dollars to pay for discount points to get the better rate into your loan, they're still there in your loan balance. Not only that, but the higher number of dollars in your loan balance means that you are going to pay more in interest charges going forward. The higher loan balance keeps costing you money, even after it has been refinanced. If you sell and buy something else, it means you're going to have fewer dollars available, and therefore the loan balance on your new property will be higher and you will be paying higher interest costs because of it.

Copyright 2015 Dan Melson. All Rights Reserved.