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What are back points?

Back points, or yield spread premiums as they are more formally called, are commission points paid to the loan originator that are hidden from the borrower. You have heard advertisements that say that if you refinance your current loan, your payment will decrease, your loan amount will not increase, and not a penny will come out of your pocket. Common sense tells you that the company offering the loan has to be making money somehow.

Example: Assume that you have a current interest rate of 8%. Your payment on a thirty-year loan is $1,467.53. Also, assume that the best current interest rate you could get is 6%. The company offering the loan is simply a mortgage broker placing the loan with a lender for a fee. If the lender can get a high enough interest rate, the lender is willing to pay the fee. If you get a loan at 6.5%, the lender is getting a .5% premium. On a $200,000 loan, this costs approximately an extra $1,000 per year. The lender is willing to pay the broker offering you the loan a point (1%) for placing the loan. The broker gets $2,000, and you get a monthly payment of $1,264.14, with no money out-of-pocket.

Because the lender is subsidizing your payment of the point, the loan may contain a clause saying that if you pay it off before a certain time, you will have to pay a penalty. This will give the lender back the subsidy if you do not pay on the higher rate long enough to make up the back point paid on your behalf.

If you are using a mortgage broker for a loan with no points; ask what the broker will receive from the lender and how it will affect your loan. If the loan has no points or fees, and the broker says that there are no back points, find a more truthful broker. You know the broker has to be paid by someone. Some questions to ask the broker include the following.

• What is the difference in the interest rate between the no points loan and a loan with one or two points?

• How long must I pay on the loan with points before I break even?

• Is there a prepayment penalty on the no points loan, and if so, what is the amount or formula used to determine the amount?

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

Any rate quoted to you by a lender or mortgage broker is subject to change. Even when there are no major trends of rates increasing or decreasing, rates change daily. Since even one-eighth of 1% can mean a difference of thousands of dollars over the life of a loan, it is important at some point to have the lender commit to a definite interest rate. This is called locking in the rate. There will be a fee charged to lock in the rate, which will vary depending on the duration of the lock. Locking in your rate for sixty days will cost more than locking it in for thirty days.

When rates are falling, lenders will offer a low-cost lock-in fee or even lock in your rate for free. Some will offer a float down. This means that if the rate falls after you lock in, you can get the lower rate. Common practice is that if rates fall after you lock in, you pay the higher rate. Lenders say they are taking the risk that rates will rise, so the borrower should take the risk that rates will fall.

The liberal policies, like no-fee locks and float downs, are usually for adjustable rate loans only. The lock only applies to the start rate, which will last no more than a year (more likely three to six months). The rate then adjusts as agreed in your loan documents, regardless of your lock-in rate. The lock on a fixed rate loan can set the interest rate for as long as thirty years.

Lenders' lock-in policies vary, and you should be clear that you understand the policies of the different lenders that you are considering. Ask for the information on rate lock-ins in writing. The policies are not simply in the mind of your loan representative. They are written somewhere and should be made available to you so that you can make a well-educated decision.

From the Expert

A lender will have a policy less favorable to the borrower on a fixed rate loan compared to an adjustable loan, since the rate will not change over the entire loan period.

If you know your lender's policy regarding locking in your rate, you have one more bit of knowledge to help you decide which lender to use. The lender with a less favorable lock-in policy may still offer the best overall program. You will not know this unless you know all aspects of the cost of loans, including lock-in costs.

When rates are rising, lenders charge more for locking in the rate and sometimes a disproportionate amount for a long lock-in. It is important that you compare the costs of the lock-in periods and weigh them against the chances of rates increasing that quickly. If rates are relatively stable, you can usually save money by locking in closer to closing time, such as thirty days rather than sixty days. A good loan representative or mortgage broker can keep track of rate changes daily. If there is a little dip, he or she can alert you to lock in. You can follow mortgage interest rates yourself in financial newspapers, financial sections of some major newspapers, or on the Internet. Type "mortgage rates" into a search engine and take your pick.

What is an assumable mortgage?

When talking about interest rates, there are a couple of other things you should know. Clauses can be inserted into mortgages that really only have impact in times when it is anticipated that interest rates will be changing. Often, these clauses are not inserted at all, but depend on your anticipated circumstance and market conditions when you want to sell your home (or, in some cases, buy a home).

An assumable loan is one that can be taken over by a buyer of the mortgaged property. In a market where interest rates are going up, it can be a major factor in a sale.

Example: You have a mortgage against your property with an interest rate of 6%. When you decide to sell your home, interest rates are 8%. If a buyer can assume your 6% loan instead of getting a new loan at 8%, your property becomes more desirable. You may even be able to get a higher price and still save the buyer some money.

Lenders are, of course, aware of the loss they will take if a buyer assumes the low-interest loan rather than getting a new, higher- interest loan. To prevent this, they rarely offer a fixed rate loan that is assumable. They instead restrict assumable loans to those mortgages that call for the interest rate to adjust to market rates.

What is a prepayment penalty?

The prepayment penalty is used most effectively in a falling interest rate market. If your mortgage is 8% and rates when you decide to sell are 6%, your buyer is not going to want to assume your loan. Lenders know that having 8% loans replaced by 6% loans is not as profitable as continuing the 8% loans, and so they charge a prepayment penalty.

Simply put, a prepayment penalty means that if you pay off or pay down your loan too soon, you pay a penalty. Since there is generally a surge of refinancing as interest rates fall, the lender makes up some of the loss that is incurred by replacing high-interest loans with lower-interest loans.

There is no standard prepayment penalty for all loans. The most common prepayment penalty clauses are reviewed with the specific loans discussed in later chapters. When you apply for a loan, always ask if there is a prepayment penalty.

 
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