First, a clarification on cost…
During a typical loan application, the two questions I get asked most often are: “What’s your interest rate?” and “what are the closing costs?”.
They’re great questions, really, but like most great questions, the answer isn’t as simple.
First and foremost, there are several different categories of closing costs to consider. Some of the closing costs are controllable (like discount points and lender credits) and others are more immutable (like third party fees). In order to answer the question, it’s important to first know what the costs are.
Lender fees, sometimes known as “origination charges” are the fees that are paid directly to your lender. These fees are collected to pay for services necessary to process your loan application, underwrite, and fund your loan successfully. The amount charged will vary from lender to lender, and it really depends on how streamlined your process is going to be later on. When it comes to processing your loan, typically you get what you pay for. Lender fees cannot be waived under normal circumstances, but some lenders, such as loanDepot, may have special benefits stating if you do one refinance or purchase through the company, they will waive any subsequent lender fees for you the next time around on that same property. Either way, when you’re searching for the right company to work with, it’s smart to ask how much your loyalty will be worth in the future.
In addition to the fees that a lender is going to charge to process your loan, there are other companies who preform necessary services to ensure your loan is able to fund both safely and successfully, and they also require compensation for their work. Third party charges include:
1. Title—At the beginning of the mortgage transaction, a title insurance agent will be hired to review public records and search for any claims against your property, including tax liens and judgments. He’ll verify whether the claims are still active and how they can be cleared. In addition to this, he’s also responsible for verifying any additional expenses affecting the property such as real estate taxes and association dues. Each state has different laws governing how a loan closing must be conducted, but typically the title agent, notary, or an attorney will ensure all required documents are signed, delivered to their appropriate parties, and recorded with a local government recording office.
In addition, title insurance will be required on your property as it will protect both yourself and the lender in case anyone makes a valid claim of ownership against your property that was not discovered during the original title search.
While these fees can’t be waived, you don’t necessarily need to work with the title company and/or attorney that your lender recommends. If you find a better deal with your own title company or settlement agent, you’re more than welcome to hire their service instead.
2. Appraisal Fee — Lenders need to preform appraisal inspections to ensure that your collateral (I.E. your house) is sufficient to cover the money they lend to you in case of default or foreclosure. Appraisals are not something you’re able to shop around for as they need to be completed by an independent third-party appraiser, for both your protection and the lender’s. In addition, it’s typically the only expense you’re required to pay out-of-pocket (aside from a credit report fee). Depending on the type of loan you’re doing, the amount of equity you have, assets, and your credit-worthiness, you may be eligible for what’s called a Property Inspection Waiver, which would allow you to completely waive the appraisal inspection and use a reasonable accepted value instead. You should ask your loan officer to check your eligibility as securing a PIW could save you both time and money.
3. Program-Specific Fees — Certain loan programs such as VA, FHA, or USDA loans come with their own “funding fees”. Because VA and FHA loans are guaranteed or insured (respectively), a mortgage lender will be reimbursed for any loss they suffer in case you default on those loan types. Because of this, lenders are able to offer lower interest rates on FHA and VA loans, which can save you money long-term. The catch, however, is that the money they use to guarantee and insure those loans needs to come from somewhere. Hence the funding fees.
- VA Funding Fee — This is a fee charged by the Department of Veteran’s Affairs which varies depending on how many times the veteran has used his VA benefits. For first time use, this is 2.15% of the loan amount, for subsequent use, it’s 3.3%. Fortunately, this fee can be financed and doesn’t need to be paid out-of-pocket. Also, it may be waived if the veteran has a service connected disability.
- FHA “Upfront Mortgage Insurance Premium” — This is a fee charged by the Federal Housing Administration to help insure FHA loans. This fee does not need to be paid out-of-pocket and is most commonly financed on top of the loan amount. The UFMIP is always 1.75% of the loan amount and cannot be waived, however, if you are refinancing from a previous FHA loan to a new FHA loan, you may be eligible to have a certain portion of your old fee refunded.
4. Transfer Taxes — This is a tax that’s collected in certain localities whenever property changes hands or when a mortgage loan is made. It can be quite large, especially in New York, but it’s set by the state and local governments. City, county, and state tax stamps may need to be purchased as well. Can it be waived? Well, this is Uncle Sam, after all, and Uncle Sam always gets a piece of the pie.
Discount Points/Lender Credits
Lender fees and third-party charges probably sound pretty straight-forward and reasonable, but discount points? What the heck are those?
Well points, in my opinion, are the most misunderstood and under-appreciated “cost” on every loan I’ve ever done. The amount you pay in points is something you have almost direct control over, but ironically the more you pay, the more you save. That may sound a little counter-intuitive, but I’ll explain…
Every interest rate has a cost.
Interest rates are calculated based on your credit score, equity position, assets, and income. Essentially the less risky you are, the lower the interest rate that you qualify for. The more risky you are, the higher your interest rate is going to be.
The interest rate that you qualify for is called the “par” rate, which is really just a term that means “the interest rate you can get without paying points”.
Let’s imagine you’re a borrower who has average credit and you have 30% equity in your house. You’ve owned the house for two years now and you’re looking to refinance your loan to lower your interest rate and make your payments more affordable overall.
Right now, you have a 4.75% interest rate, and you pay $1,304 / month between principle and interest. You’ll pay a total amount of $219,500 in interest over the life of the loan.
You call to get a quote and find that the rate you qualify for is a 4.375%, and your principle and interest payments would be $1,233 / month, saving you $71 / month. You’re only going to pay $197,000 in interest with this new loan, a savings of $22,500.
Not bad, but you were hoping for more, right? If only there was a way to secure an interest rate lower than what you actually qualified for…
Well, in a nutshell, that’s exactly what paying discount points allows you to do.
Basically, each “point” is adds 1% of your loan amount in cost, but saves you more in interest long-term. Every available interest rate charges a different amount in points, with the higher rates being the cheapest and the lower being more expensive.
Instead of taking the 4.375% you qualify for, you could pay discount points, meaning you pre-pay a portion of the interest upfront (but at a discount), and as a reward for doing so, your lender will offer you a lower interest rate so that your payments and total interest paid overall is lower.
The reason lenders are able to do this is because if you prepay a portion of the interest upfront, you now have more “skin in the game”. They’re going to immediately gain a profit on their investment, which means they have less to lose if you decide to pay the loan off early through either selling the house or refinancing again. You’ve just made the deal more valuable for them, and now they can equally make it more valuable for you.
Let’s imagine after paying points your rate will decrease from 4.75% to 3.75%. Instead of a $1,304 payment, now you’re only paying $1,163 / month, and your total interest amount is $167,500. That saves you a total amount of $29,500 from the “par” rate or $52,000 from what you currently have, over twice as much!
As you can see, paying points has both an immediate and long-term benefit; the monthly payment decreases substantially and the total interest paid is much less. Yes, paying points gives you a higher upfront cost, but it saves tens of thousands of dollars over the life of the loan. In addition, depending on how much equity you have, they don’t even need to be paid out-of-pocket and can be rolled into the loan. Unless you plan to sell the home before the break-even point, or you think you’ll be refinancing again in the near future, there’s no downside. Did I mention the tax benefits?
So how many points should you pay?
The answer to this question really depends on how long you intend to keep your house. States also have different laws governing the maximum a borrower can pay in points and fees, which also needs to be taken into account.
The formula to determine the break-even point is quite simple: cost of points / savings = months to recoup investment.
For example, imagine the par rate on a $250,000 loan was 4.75% and it could be bought down to 3.75% by paying $8,750 in points. The monthly savings between the two loans is $107 / month.
The formula is $8,750 (cost of points) / $107 (savings) = 81.77 months (6.8 years).
In this scenario, as long as you intend to stay in the house for at least 6.8 years, the investment is recouped and any additional time in the house is pure profit.
What if you don’t want to pay any closing costs?
Sometimes a refinance may be in your best interest but paying closing costs isn’t. Typically this is a situation where you know you’re going to be selling the property within the very near future, or you know you’ll need to refinance again soon and don’t want to pay costs twice.
Luckily, there is a way to do a “no-cost” loan. And I don’t mean “roll the cost in”. I mean, no cost, whatsoever.
Remember what we learned about discount points and how you can “buy” a lower rate than the one you qualified for? Well this concept also works in reverse.
You can also choose an interest rate that’s higher than where the market is and, in return, the lender will pay you for taking a higher rate. This is what’s called “Lender Credit Rebate”.
For example, imagine the same $250,000 loan. Between the lender fee and third party fees, the closing costs total $3,200. Normally you’ve have to either roll those costs into the loan (bringing the loan amount to $253,200) or you could pay them out of pocket.
If you’re only keeping the house six more months, you’d have to be saving over $500 / month for this loan to make sense. So what should you do?
Let’s say the par rate was 4.75% (again, the par rate is the interest rate that you don’t have to pay points for). What if, instead, your loan officer recommended a 5.375% and told you that if you went with that rate, the lender would be able to cover your closing costs for you, meaning they give you a credit for the $3,200 instead of you having to pay it.
In a real life scenario, the amount you receive in lender credit rebate varies from person to person depending on your qualifications, but generally the higher the interest rate, the more lender credit rebate you receive. You cannot receive more lender credit than the total of your closing costs*.
This would allow you to do your refinance without paying closing costs, meaning both your bank account and your equity remain completely intact, but on the flip side you will now have a higher payment than if you went with the par rate or paid points, and therefore you’ll pay more interest over the life of the loan.
You may be curious why it would make sense to take a higher interest rate on a loan like this, but interestingly enough, I see this happen quite often.
One client I helped recently was looking to sell her house so that her and her husband could downsize. They were both retired and their kids had gone their separate ways, so they had too much house to maintain and not enough family to help out. They told me once they sold their house, they’d use their equity to pay off all of the debt that they accumulated over the years and start fresh. The only reason they were looking to refinance was to take out $10,000 to do various repairs before putting the home on the market, and also to see if they could reduce their payment a little in the meantime.
I took a look at their credit report and saw that they were paying almost $1,500 / month on $40,000 worth of debt, not even including their mortgage. For being retired and on a fixed income, it was a lot of money they were throwing towards those bills.
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Rather than waiting half a year for when they sold the house to pay off the bills, I recommended that we simply take the $40,000 out now to pay off the credit cards and installment loans and we added the additional $10,000 for the cosmetic repairs they wanted to do before selling.
Every other loan officer was trying to entice them to do business by selling them with what they thought they needed “We’ll get you the lowest rate”, “Our interest rate will be better”, “Blah blah blah”.
My advice was in opposition to all of them. “You’re selling this house within 6 months so there’s no sense in paying for a loan you don’t intend to keep. To minimize your closing costs, I would recommend taking an above-market rate so that you can tap into this equity for free, and then you’ll have more money that belongs to you when you sell your house. Because the interest rate is higher, you’ll have to pay an extra $100 monthly, but you’re going to save $9,000 from having your credit cards paid off. Plus, it’s better than losing $3,000 of equity six months from now because you paid for a loan.”
They both loved the idea and moved forward even though I was giving them a higher interest rate than everyone else, and they even said they want me to help them with their purchase as well.
The real takeaway here is that closing costs and interest rates aren’t “one-size-fits-all”. “If you should pay” and “how much you should pay” really depends on your own unique situation, and there are many small details to consider.
That’s why it’s important to plan your loan with the long-term in mind and do business with a loan officer who’s both competent and looking out for your best interest, rather than just his commission check.
Isayah Durst — Licensed Lending Officer NMLS#1670285. The content of this article is for informational purposes only. It should not be treated as specific legal or investment advise. Get a personalized quote before making any financial decisions.