Find Out the Rates, Points Upfront
Question: My lender offered to reduce the interest rate on my 30-year, fixed-rate mortgage from 6.75% to 6.5% for another 1.5 points. Is this a fair price?
Answer: No, it isn’t, but before I explain why, I want to place your question in context.
Lenders today offer borrowers a range of interest rate-point combinations, leaving it to borrowers to select the combinations best suited to their needs. (Points are charges that must be paid to the lender upfront, expressed as a percentage of the loan amount, where 1 point equals 1%.)
High-rate/low-point combinations are good for borrowers who are either cash short or who don’t expect to be in their house very long. Low-rate/high-point loans are for borrowers who can meet the cash requirement, and either have a long time horizon or need to reduce their monthly mortgage payment.
For several reasons, it is highly desirable for borrowers to make this decision early in the shopping period, rather than wait until they are locked into a particular lender.
One reason is that the lender offering the lowest points at one rate is not necessarily the same as the lender offering the lowest points at a different rate.
For example, on April 27, I shopped 15 national lenders for a $200,000, 30-year fixed-rate mortgage in California with a 30-day lock.
For each of five interest rates ranging from 6.25% to 7.25%, I identified the lender charging the fewest points. One lender charged the fewest points at two rates, but three lenders charged the fewest points at the remaining three rates.
But there is another reason not to get locked into one lender before making the final rate-point decision, which is illustrated by your letter.
The 1.5 points you paid to reduce the rate from 6.75% to 6.5% compared with 1.125 points being charged by most of the national lenders I surveyed on the day I received your letter, and none charged more than 1.25 points.
What happened to you is that you were too far along in the process to back out, and the loan officer took advantage of an opportunity to make a few extra dollars by padding the price.
Even though you were committed to this lender, you probably would have avoided the overcharge if you had information on all the rate-point combinations offered by that lender at the outset.
They won’t change the price on you if you have already seen it. This is why some loan officers are reluctant to provide complete rate-point information to their customers.
Readers should not conclude from what I said above that a 0.25% reduction in rate should be priced at about 1.125 points. This was the price charged by most lenders to reduce the rate from 6.75% to 6.5%, but the price most of them charged to reduce the rate from 7.5% to 7.25 was only 0.75 points.
Why the difference? The lender’s loss in reducing the interest rate by 0.25% depends on how long the loan remains in force. Higher-rate loans are refinanced more quickly and therefore have a shorter life than lower-rate loans. Because the loss from the rate reduction is smaller, the price of the reduction is lower.
For similar reasons, the prices for 15-year loans are usually a little lower than they are for 30-year loans. These were typical prices of 0.25% rate reductions on April 26:
30-year fixed-rate:
6.25% to 6% 1.375 points
6.75% to 6.5% 1.125 points
7.5% to 7.25% 0.75 points
15-year fixed-rate:
6% to 5.75% 1.125 points
6.5% to 6.25% 0.875 points
7.25% to 7% 0.75 points
Early Payments: Some Benefit, Some Don’t
Q: After reading several of your articles on paying off mortgages early, I came to the conclusion that I really didn’t understand the basic rules of mortgage accounting. Can you explain them in a simple way?
A: Let me try. The accounting for amortized home loans assumes that there are only 12 days in a year, consisting of the first day of each month.
Your account begins on the first day of the month following the day your loan closes. You pay “interim interest” for the period between the closing day and the day your record begins. Your first monthly payment is due on the first day of the month after that.
For example, if your 6% 30-year $100,000 loan closes on March 15, you pay interest at closing for the period March 15-April 1, and your first payment of $599.56 is due May 1.
The payment is allocated between interest and reduction in the loan balance. The interest payment is calculated by multiplying 1/12 of the interest rate times the loan balance in the previous month. 1/12 of 0.06 is 0.005. The interest due May 1, therefore, is 0.005 times $100,000 or $500. The remaining $99.56 is used to reduce the balance to $99,900.44.
The process repeats each month, but the portion of the payment allocated to interest gradually declines while the portion used to reduce the loan balance gradually rises. On June 1, the interest due is 0.005 times $99,900.44, or $499.51. The amount available for reducing the balance rises to $100.06.
While the payment is due on the first day of each month, lenders allow borrowers a “grace period,” which is usually 15 days. A payment received on the 15th is treated exactly in the same way as a payment received on the 1st. A payment received after the 15th, however, is assessed a late charge equal to 4 or 5 percent of the payment.
When borrowers elect to increase the amount of their payment, the increment reduces the balance by the same amount.
For example, if the borrower paid $699.56 on May 1, the balance would drop by an additional $100 to $99,700.38, which in turn would reduce the interest due in June to $498.51. This would be the case regardless of when during the month the additional $100 was received. For example, the borrower could pay $599.56 on May 15 and $100 on May 30.
These rules are advantageous to many, perhaps most borrowers because of the backdating of payments to the first day of the month.
Thus, the borrower who pays $599.56 on May 15 has the use of $100,000 free of interest for 15 days. Similarly, paying $100 on May 30 to reduce principal avoids interest on the $100 for 29 of the 30 days in May.
My mailbox, however, is stuffed with letters from borrowers whose needs are not met by this instrument. The major problem is the absolute rigidity of the payment requirement.
Skip a single payment and you accumulate late charges until you make it up. If you skip May, for example, you make it up with two payments in June plus one late charge, and you have a 30-day delinquency report in your credit file. If you can’t make it up until July, the price is three payments plus two late charges plus a 60-day delinquency report in your credit file. Falling behind can be a slippery slope into foreclosure.
Payment rigidity also prevents many borrowers from organizing their personal finances in the best way. Some examples from my mailbox:
* Borrower A wanted to use a bequest to reduce the monthly payment on a fixed-rate mortgage. No way. If A used the bequest to prepay principal, it would shorten the period to term, not reduce the payment.
* Borrower B wanted to use a bequest to reduce the term on an adjustable-rate mortgage. No way. If B used the bequest to prepay principal, it would reduce the payment, not shorten the term.
* Borrower C wanted to double his payment in December when he receives his bonus and skip a payment in August when he has no income. No way. If C used the extra payment in December to prepay principal, he still had to make the payment for August.
* Borrower D is paid twice a month and wanted to make his mortgage payment twice a month. No way. Borrower D must bank his mid-month payment and pay the lender once a month.
No one instrument will meet everyone’s needs. Many borrowers who actively manage their family finances, however, are ill-served by the current amortized mortgage.
Jack Guttentag is a syndicated columnist and a professor of finance emeritus at the Wharton School of the University of Pennsylvania. Questions or comments can be left at his Web site at https://www.mtgprofessor.com. Distributed by Inman News Features.
