Friday, April 19, 2013

No Such Thing as a Free Mortgage Loan - Don't Get Suckered

Loan Fees Have to be Paid.  Their Cost May Be Buried, but You're Still Paying These Fees

As a mortgage broker and a mortgage banker, there's no easier way to market myself than to call somebody up and say, "I'll give you a no cost loan. You'll sign some papers, it's not going to cost you anything.  We'll be able to lower your interest rate, and you can save some money."

Sounds great.  It's fun to market something that’s FREE.  But in this fantasy conversation, I would then spend a little time with my clients and friends, and point out to them why I think that a “no cost loan” is a bad idea.  Remember the adage that we all know that there's no free lunch.?  I believe this is true about mortgage loans.  It's certainly true here in California, but probably in every state in the country.

If you're going to do a real estate transaction, there are certain third party fees that must be paid. You must have:

    •    an appraisal,
    •    an escrow company handle the transaction
    •    title insurance
    •    the deed recorded by the county
    •    the mortgage notarized.

The people and companies that do this type of work are not doing this for free.  Someone is going to pay them.  If you go to a bank or broker and they offer a no cost loan, I guarantee you that bank or broker is paying those third parties those fees.  The bank or broker isn't doing it because they like you or because they're offering a no cost as a way to get you in the door.  They're doing it because they are going to make money, a profit from the transaction.

Paying the Loan Fees in a Higher Interest Rate

 The only way they're going to make money if they've laid out a couple thousand dollars for these fees is to make it on the interest rate.  If it's a bank, higher interest rates means higher payments, and they make it back over time.  The point is, you shouldn't be concerned about how they're going to make their money back, it's how you're going to pay for it.  And you're going to pay for it in a higher interest rate. That higher interest rate means that you're going to pay something more per month in every monthly payment, and that's going to add up over time.

If you get a no cost loan, your interest rate, which I am estimating based off of today's market, on a $500,000 loan for a 30 year fixed rate mortgage, is around 3.6%.  If you want a no cost loan, that rate might be 3.8%.  It's not a huge difference.  The difference in payment in $500,000 could be about $30 a month. The transaction cost for doing a loan like that here in California will run about $3,200 or $3,300, between the escrow and the title insurance and the appraisal and the bank fees. That $3,200 is absorbed by the bank or broker when you do the rate at 3.8%.

So the analysis you want to do is, is it worth my paying $30 more per month, to save $3,200 today. Simple division, that's around 90-100 months worth of payments.  That's 8 or 9 years worth of a loan. Are you better off having $3,200 in your hand today which you could invest, and pay the extra $30 a month?

Sure. But what if the numbers came out so that the money you're giving back to the bank, you'll wind up giving back to them in 4 years?  It's a different scenario.  Now maybe it's not so great having a no cost loan.  You'd be better off locking in the lower interest rate, because over time, it's going to make sense for you.  If you're looking at a 30 year loan, you should really only be looking at that product if you're thinking of holding a loan for 8, 9, or 10 years.  Otherwise, there is much better products out there for you.  So thinking long term, the lower interest rate might always turn out to be a better deal.

Here Is a Better Way to Handle Transaction Costs

Then, there is one other way to handle the transaction costs, and this is the way that I find almost always is the most sensible for someone. Rather than pay the cost in cash, rather than have the bank pay your costs and you have to have higher interest rate, and assuming you have enough equity in the property to allow this on the loan, I would say take those dollars and add them to your loan amount so they're amortized over the period of time.

Using the cost again of about $3,200 dollars, and your interest rate is in the mid to high 3's, let's say that costs about $17 a month. Paying the higher interest rate was shown to be about $30 a month. Potentially you're better off adding the money to your loan amount, because even though your loan amount might now be higher, your payment will still be lower, and over time.  That lower interest rate is going to save you a tremendous amount of interest costs.

Most everyone you talk to understands that a loan is amortized and that each payment is going to have a portion of principal and a portion of interest. Over time, they're going to cross. You will pay more principal each payment, and corresponding you will pay less interest each payment. What most people don't appreciate is that the lower the interest rate, the greater the percentage of the principal you pay from the get go. So if you have an interest rate of 6%, your first payment might be about 35% principal and 65% interest. If you have an interest rate of 3.5%, you're probably paying about 60% principal and 40% interest. Having a lower interest rate isn't just saving you interest, but it's forcing more of your dollars to go to the principal from the get go.

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