Mortgage Secrets 'They' Don't Want You To Know About - Part 1
When the Lowest Rate Makes the Most Sense
The lowest rate never makes the most sense. Or, hardly ever. Sounds like something a lender with high rates would say, huh? Well, hear me out. First, the rates I offer are extremely competitive. Lowest in the industry? Nope, and for good reason (if you've seen the recent better.com layoff saga, you're witness to how the companies with the lowest rates are run). But our rates are always competitive, and I still don't think most people should opt for the lowest rate. I don't have the lowest rate I could have gotten on my home. Neither do my parents. Why? Because strategy, cost, and long term planning is more important than rate.
The lowest rate offers the most benefit to a home owner long term, over the course of the life of the loan. Why? Because the lowest rate comes with the highest cost. Check out the table below. What you're seeing is a sample rate sheet, and from left to right the numbers are Rate, APR (skewed because no closing costs are factored into this sample), P&I (principal plus interest, aka your monthly payment), discount/rebate as both a % (points) and dollar amount. Remember, one point is 1% of a loan amount, so you're seeing fractions of points as a % and a dollar amount, that is what it costs to get that rate (positive numbers), or the dollars that would go back to the borrower as a lender credit (negative numbers).
Now knowing that, think of all the people you know that have taken out a mortgage then paid that mortgage off over the amortization period - that is, the length of the original loan (in most cases, 30 years). If you happen to know someone that has, you can rest assured of 2 things. 1) It's not common and I'd bet all the people you know who have done it could be counted on less than 3 fingers, and 2) you should have been a better friend and talked that person into refinancing at some point because when they got their loan the rates were in the double digits!
What does this have to do with rate? Well, look at the difference on this chart between 3% and 2.99% - sure, the person with the lowest rate can tell people their rate starts with a '2', but they paid $313 to get the lower rate at a difference of $1/month. So if they have their loan for just over 26 years, the lower rate will finally pay off. Now let's look at the difference between 3.25% and 3.5% - in this scenario, there's a monthly payment difference of $35. There's a difference in cost of 1 point, or in this case, $2500. If we divide the cost by the monthly payment difference, it shows that the "breakeven" on when the lower rate would start paying off is 71 months, or just under 6 years. So at 6 years, the lower rate makes sense, right?
Wrong. It certainly makes some sense. But, what if rates drop during those 6 years? If they drop enough to refinance, the cost of the lower rate would have been wasted. If the home is sold and the loan is paid off, again, the lower and more expensive rate is a waste. But beyond that, if, instead of paying $2500 to get a lower rate, that $2500 invested with a 5% return over 6 years would be worth $3350. So you can see, that even at 6 years when the 'breakeven' point occurs, there is still an extended period before the lowest rate is the best use of money. Of course, if you take the up front savings of $2500 and spend it on bubble gum, it's probably not the smartest move, but if you consider the big financial picture, getting the lowest rate either rarely makes sense, or makes sense over a fairly long period of time.
Does it ever make sense to get the lowest rate? Sure. Well, maybe not the lowest rate (rate sheets get really expensive really fast when you go too far outside of 'normal market' rates), but a lower rate makes sense in a few circumstances. If you know you'll have a loan for a long period of time and you expect a rising interest rate environment (which we haven't seen in the US since the 80's), the lowest possible rate makes sense. If the cost of a lower rate is really low and creates a breakeven point of just a couple months or (again, if you'll have the loan long term) a couple years, then it can make sense as well.
Consumers have been conditioned to shop on rate. Why? It's easy to market, and easy to sell as a lender. Compare rates, pick the lowest, it has the lowest payment, and we close! And to be candid, most people aren't financially savvy or well versed in financial planning, so choosing a loan based on rate or APR is the easy way, albeit not necessarily the smart way (APR includes costs of a loan and therefore is advertised as a superior way to shop, but it also has it's pitfalls - for example, an APR can be lower or higher based on absolutely no differences to the loan other than which day of the month it closes - how does that help anyone??).
Further, lending at higher rates, despite the seeming benefit to the lender in the form of more interest paid, is risky business for banks. Why? Well, using the example above, someone has to pay that lender credit. The bank is banking on (pun intended) a borrower making payments long enough to offset the initial lender credit. If a borrower refinances, sells their home, or the mortgage is paid off early for any reason, the bank loses.
The Fine Print
When shopping for a loan, rate is certainly important. APR is as well. It's extremely important though to consider the total cost, along with some intangibles like the length of time to be spent in a house, if rates are rising or falling, and economic factors that your loan officer should be aware of (for example, as of writing this, we see a tightening yield curve and Fed action that could trigger a recession - typically a falling rate environment). If you're shopping lenders with the lowest rates, don't expect professionals that can give sound advice or offer much beyond a rate quote. And if you're shopping for the lowest rate, consider this post, and read the fine print - if a loan with a low rate is costing you an arm and a leg (or thanks to inflation, perhaps 2 arms and 2 legs), think twice about the real value in the lowest rate - usually, there is none.
Comments(13)