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Chapter 4. Interest

┠What is interest, and how are interest rates determined?

┠How do interest rates work?

┠What are points and buydowns?

┠What are back points?

┠How do I lock in the interest rate on my loan?

┠What is an assumable mortgage?

┠What is a prepayment penalty?

What is interest, and how are interest rates determined?

Most people believe that the most expensive purchase they will make is buying a home. They make offers below the asking price, trying to save a few thousand dollars. If a low offer is accepted, they are elated. Then, many of them secure a mortgage loan that ends up costing them tens of thousands of dollars more than they should be paying.

Example: A thirty-year loan will almost always cost more than the property. If you buy a home for $100,000 and get a 7% loan for thirty years for $100,000, the total interest on the loan would be $139,508 — making the loan cost you more than the home is worth. The same loan at 6% would have a total interest of $115,838.

Suppose you paid 7%, but took the loan for fifteen years. The total interest would be $61,789.40, which is substantially less than the purchase price and less than half of what you would pay for the thirty-year loan. The fifteen-year loan at 6% would cost you $51,894.80 in interest.

You can easily see that negotiating the right loan may be more important than negotiating the purchase price of the home. It would be impossible to buy a home listed at $100,000 for $12,386.80. It is possible to save the $87,613.20 on your mortgage by getting a 6%, fifteen-year loan instead of a 7%, thirty-year loan. If you are going to borrow $200,000 or $300,000, the savings are even more dramatic.

How do interest rates work?

When you use someone else's property, you pay for its use. This is called rent. People rent everything from apartments to cars to carpet cleaners. The longer you use whatever you are renting, the more you have to pay. When you want to buy a house and do not want to, or do not have enough money to, pay cash, you basically have to rent the needed money. The rent you pay for the use of this money is called interest.

Interest rates are determined by some factors over which you have no control, as well as some that you can control. The rates set by the Federal Reserve that affect mortgage interest rates, for example, are beyond your control. Factors you can control that influence interest rates include the type of loan (fixed rate, adjustable, or hybrid), the term (length) of the loan, your credit score, your down payment, and the loan-to-value ratio. You can also take some steps to lower your interest rate by buying down your rate.

What are points and buydowns?

A point is simply 1% of the loan amount. It is usually paid in a lump sum when you get your loan. In some cases it may be financed. There are two types of points:

1. discount points, which can directly lower your interest rate; and,

2. origination points.

Example: You want to borrow $150,000. One lender offers a no points loan with an interest rate of 6%. Another lender offers a two points loan at 5.5%. By paying the two points, you are buying down the interest rate. Which loan is better?

There are two things you must consider to determine the answer to the problem in the example. First, type "mortgage points" into any search engine. There will be several sites for mortgage calculators. For the example, the monthly payment on a thirty-year loan would be just under $50 less per month on the two point 5.5% loan. It would take a little over five years to make the two points loan the better deal. Type in your specific numbers and you will be able to figure out the break-even time for the loan amount and percentages you are comparing.

Now for the harder part. How long will it be before you pay off the loan? Are you planning to move within five years (before the break-even time)? If you plan to move in three years, you would want the no points, 6% loan. If you end up staying in the property seven years, you will save money with the two points, 5.5% loan. While predicting when you will move in the future is no easy task, most people underestimate the time they will keep their property.

An advantage to discount points is that they are considered interest and are currently tax deductible. Since tax laws change frequently, always get advice or research current deductions for mortgage expenses before filing.

A buydown over the life of a fifteen- to thirty-year loan will not cause a significant difference in your interest rate. The estimate on a thirty-year loan, for example, is one-eighth of 1%.

The buydown is most effective over a short period. If you buy down your interest rate for the first three to five years of your loan, the rate and monthly payment will drop enough that it may mean the difference between qualifying and being rejected.

The second type of point is the origination or commission point. These are lender fees or mortgage broker commissions. They do not lower your interest rate or any other costs of the loan. They are necessary payments for the service that you receive. However, avoiding these fees may not save you money. Paying a fair commission to an honest and competent mortgage broker may be insignificant compared to the money he or she will save you on your mortgage loan.

From the Expert

Since the lender will give more weight to lowering your monthly payment than having some cash in the bank, you can accomplish more by using available cash to buy down the interest rate.

 
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