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Price vs. Cost

Price vs. Cost Analysis

When evaluating a proposed home loan, the first thing that must be done is differentiate the “price” of the home loan from the “cost” of the home loan. The price of something is how much you pay for it initially, while the cost of that same item is how much you spend over time for that item to remain operational. When considering a home loan, it is clear that there are two very different types of expenses, closing costs, and your monthly mortgage payments. In the mortgage industry these are known as reoccurring (cost) and non-reoccurring (price) closing costs. The re-occurring costs include interest that will be paid on the home loan, while the non-reoccurring costs refer to the closing costs that will be collected in escrow when finalizing the loan. Due to the various ways home loans and their associated fees can be structured, and as a means of evaluating different programs between one another, our government requires the disclosure of a representative number that consolidates the total cost of the loan weighted proportionally, and represents it in a single rate known as your Annual Percentage Rate or APR.  

Regardless the APR is not a final measurement, and this type of evaluation requires a more in depth analysis. There are four primary points that must be considered when considering a price vs. cost analysis: the interest rate, the cost of closing, the term, the loan program.

The type of program that is in question is very important because different programs are going to produce different figures, therefore it is important to compare like programs when evaluating price vs. cost. Comparing two different programs is going to make this type of evaluation subjective by introducing risk and security. In addition the program you are applying for will have internal guidelines, so if you decide to change the terms of the loan (how much you are borrowing, cash out or rate and term, primary residence or investment property, credit score, etc…) but want the same program, you may inadvertently change the terms offered for that program so do your best to avoid this type of situation when possible.

The term is the most expensive part of a home loan which is why it is an independent point. It is the largest contributor to cost. Extending the term guarantees a higher cost because you will be required to make more payments. A 200,000 dollar loan fixed for 30 years at 5% interest has a payment of 1,073.65; over 30 years or 360 payments you will have spent 386,514. A 200,000 dollar loan fixed for 40 years at 4% interest (one full point lower) has a payment of 835.88; over 40 years or 480 payments you will have spent 401,222. Despite the lower interest rate and payment you will have spent 14,708 more due to the term. Accepting the shortest term possible will reduce your cost significantly, moreover interest rates are more often than not better for home loans with shorter terms (less risk to the lender) so you get the best of both worlds.

The interest rate is going to have a large effect on your cost, after all the lower the interest rate the lower the monthly payment on your home loan will be, therefore it goes without saying you want to get the lowest rate possible, so you have two choices wait for a lower offered interest rate, or buy the interest rate you want. The first option is what most people elect to do, unfortunately they are operating on a hope rather than fact that the market will move in the right direction in the timeframe they require.  If this is your plan it is important that you are paired up with a professional that keeps a close track of the market you will be participating in (there are different markets the largest being the Mortgage Backed Securities or MBS). If this is your plan and you do not have a loan consultant you trust that actively watches these markets and knows your future plans and when to contact you, and you are relying on your local newspaper, random internet searches, or the network news; it is highly recommended you seek professional help immediately and find a home loan consultant that watches these markets and is focused on your goals rather than an immediate commission. If on the other hand you are already in a position in which you must close and buying the rate down is an appealing option, you must take a close look at the cost of closing.

The cost of closing is going to include all of the upfront fees required to close the loan. These fees will include third party title, escrow fee and recording fees, interest per day, impounds to establish the accounts (if you are going to have impounds), lender underwriting and processing fees, cost of the interest rate (if this applies), loan origination fee to your loan officer (whether borrower or lender paid it should be represented), the appraisal fee, etc… There are a couple of ways to handle the cost of closing: you may choose to bring cash in to closing, or you may choose to wrap the cost of closing into the loan amount. The first option listed here will mean bringing cash to the table out of pocket; the advantage to this option is your home loan balance remains low, and the lower the initial loan amount, the less you will pay in interest over the course of the loan. The second option allows you to complete home financing without bringing money to the table, but the disadvantage is a slightly higher loan balance to cover the closing costs (in a refinance) or a higher rate to produce credit to pay these costs, which means a slightly higher payment. If you are highly concerned about cost (long term expenses) and motivated to reduce your principle balance as quickly as possible, the first option listed here would make the most sense for you and it is taking true advantage of the “price” concept. When price is what matters you should consider the borrower paid compensation model. For most people however, financing the cost of closing into a home loan and paying a slightly higher payment for not having to come in with cash to close is a reasonable compromise and this is the direction they go. When "cost" is not as important as price, you should look at the no cost option of lender paid compensation model.  

A no cost loan is accomplished through the lender paid compensation model and by you accepting an interest rate that is above market. The yield spread paid back can then be used to cover the closing costs listed above. The clear disadvantage of this is because you are accepting a higher interest rate your monthly payment will go up. If you know you will be selling or refinancing your home in the near future this is a better option because a no cost loan has the lowest price, but the highest cost associated with it. It actuality should be called a no price loan.

Here is an example that demonstrates the price cost relationship for a rate and term refinance (program) covering 195,000 dollar home loan currently at 7% interest with a payment of 1,330.60 set to adjust up to 8% next month on their primary residence (program). The client wants a 30 year fixed (program/term) and to know there options:

So we know the general program – rate and term refi, primary residence, and a fixed rate – and we know the term – 30 years. Closing costs will be approximately 4,000 dollars all inclusive, and clearly this is something the client needs to move on because of their currently high and adjusting interest rate. The proposed interest rate associated with these closing costs is 4.875%. If you were to elect to pay the closing costs out of pocket your loan amount would stay the same 195,000 dollars now at a rate of 4.875% with a payment of 1,031.96. If on the other hand you elected to wrap the closing costs up into the loan you would have a new loan amount of 199,000 at a rate of 4.875% with a payment of 1,053.15. The advantage of not having to pay closing costs out of pocket is 4,000 dollars; the disadvantage is a higher payment of 21.19. It would take 189 months or about fifteen and a half years to make up this difference which is why most people elect to wrap the cost of closing into the loan; the chances of moving or refinancing within fifteen years is substantial. Then again, if you plan on trying to pay down your balance quickly, or will be holding onto this loan throughout the duration paying the fees out of pocket will save you money as demonstrated by the numbers above. Both of these options represent high price but low overall cost home loans. If we went the other direction we could drastically reduce the price, but the cost would increase. If this client decided to accept a higher interest rate than the market offered say 5.875% that rate would pay the originating agent a rebate, and if the agent was willing to credit the rebate towards closing you have yourself a no cost loan. 5.875% pays a rebate of 2.125% which means the originating agent would make 4,143.75 in rebate off of a 195,000 dollar loan. They could credit 4,000 to cover the closing costs (the additional 143.75 they keep), and you have yourself a no cost loan. The disadvantage is the higher interest rate. 5.875% on a 195,000 dollar loan has a payment of 1,153.49, which is 100.34 higher than the same loan with closing costs wrapped into a new loan balance of 199,000. It would take 40 months before the higher payments cost you more than the closing costs associated with the lower rate (4,000 dollars), so if you were planning on selling or refinancing inside this time period, the no cost loan would make more sense than the low cost loan it is compared to. 

This can be applied to any type of home loan a 30 year fixed, a 5/1 ARM, a 10/1 ARM interest only, etc… by evaluating this price cost relationship inside the program you are looking to take advantage of, you can identify the best fee structure based on your particular situation, which does not always transpire into the lowest APR, which is why you cannot look to this figure as the final determining factor. A no cost loan will have a higher APR than a low cost loan because of the difference in interest rates, but if your plans warrant a no cost home loan, the higher APR should not concern you. If on the other hand you are looking for long term financing that will stand the test of time, securing the lowest possible APR should be a primary focus.

Generally speaking a low cost loan with fees wrapped into the new home loan will cost you far less than any no cost loan. In our above example 199,000 dollar loan at 4.875% had a monthly payment of 1,053.15 while the no cost loan although smaller (195,000) had a payment of 1,153.49. Over 30 years the low cost loan will cost you 379,134 (1,053.15 X 360), while the no cost loan would cost you 415,256.40 (1,153.49 X 360). The conclusion, paying a higher price will mean spending less in cost over the course of the loan, cost is always more expensive than price, and should be taken advantage of in specific situations only that require short term solutions.

Whatever your situation, if you are working with an experienced loan officer that understands the details and consequences – good or bad – of price cost structure, you should be able to work through your particular situation and identify the most advantageous solution based on your future goals.

We are committed to servicing our clients and assisting them in evaluating the fee structure of all loans recommended. For your own detailed free evaluation from a professional with no obligation please feel free to contact us.

831.325.6959.

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