Over the past couple of months, we’ve been looking at the factors affecting pricing for mortgage interest rates. The general financial market, your credit score, and loan-to-value are just some of the elements that are used to determine the pricing for a particular interest rate.
Here, we are going to look at interest rate pricing for a particular loan and the effect a lower or higher interest rate can have on the costs associated with getting a loan. Lenders don’t loan money for free. Using the parameters we’ve covered in part one and two, they develop a pricing table for each particular loan. In the computer era, it’s as simple as a loan officer entering the various loan parameters and the computer system will show a breakdown for a particular loan across a wide variety of interest rates. Our loan in today’s example is a purchase, a $350,000 loan on a property that appraised at $437,500, which makes the loan-to-value (LTV) ratio 80%. The borrower has excellent credit with a mid-score of 800.
After taking an application and checking the borrower’s credit, the loan officer can price out the scenario. If the loan officer is a mortgage broker, they may be able to price the scenario across a portfolio of different lenders, tailoring the lender to the borrower’s specific circumstances. If the loan officer works for a bank or credit union, that loan may be originated and funded in-house, which could potentially limit the loan options available. When considering a mortgage, it’s usually a good idea to shop with a few different lenders; not all are created equal. Would you buy a car from the first dealer you talk to? Probably not, and your mortgage should be no different!
The loan officer may price out lower interest rates that charge discount points as well as higher rates that offer a lender credit. But what is a discount point, what is a lender credit, and what does it all mean?
Remember, lenders don’t loan money for free. They earn money on the interest you pay. In exchange for a borrower taking a loan with a higher interest rate, a lender may be able to offer a lender credit, which is exactly as it sounds. A lender credit is a credit from the lender, which the borrower can use to offset closing costs. Typical closing costs for a home purchase are 3-6% of the loan amount. Lender credits can be used to offset many of these closing costs which means a borrower may not be required to bring as much cash to closing. As a result of this credit, the borrower accepts a higher interest rate. If a particular interest rate were crediting the borrower 1%, in the case of our $350,000 loan, the borrower would have a $3,500 credit applied towards their closing costs.
On the opposite side of the spectrum from lender credits are discount points. A discount point is essentially prepaid interest in exchange for a lower interest rate. A discount point is equal to 1% of the loan amount. So for our $350,000 loan, if a borrower were to pay one discount point for a particular interest rate, they would pay $3,500 for that particular rate.
There’s generally a “par” rate a lender can offer, which offers neither a credit nor charges discount points. Rates higher than this “par” rate will be offset with lender credits. Rates below this “par” rate will cost discount points. As a consumer, you should evaluate your particular situation to determine whether or not it’s worthwhile to pay for a lower interest rate. Generally, the longer you plan to own a property, the more advantageous it may be to pay the additional cost for a lower rate. Your loan officer can provide you with monthly payment information and closing costs for various interest rates. Using this information, you can determine how long it would take to “break even” if you elect to pay points for a lower rate.