When shopping for a mortgage, the lowest rates may not be the best rates. Our society is sucked in to finding the lowest rates so much that many consumers are missing the big picture. Let me help you understand why the lowest rate is not always the best rate.
I drive by several banks and credit unions on a weekly basis. Most of them have an electronic sign outside their building that advertises their rates on home loans. I have seen this ever since I was a little kid. It becomes part of our psychology: Lowest rates are the best rates. Not because that’s what we were necessarily taught, but because that is what the banks and credit unions have implied through their marketing.
There is a lot that goes into an interest rate that most consumers do not understand. Why would they? This is not something taught in our education system and it takes months for new loan officers to understand this concept. You have options with your interest rate. To illustrate this, I am going to try and use simple numbers. These numbers are not real and are solely to illustrate the point. It’s also important to understand that the interest rate is not the same as the APR (annual percentage rate).
The Interest Rate Conversation
Let’s say we sit down and discuss interest rates for the current market and the going rate on a mortgage is 5%. A loan officer should have a list of multiple interest rates that come with a price. This is called a rate sheet. The 5% interest rate does not cost any discount points or have any credit available. Discount points are a term used for a cost of buying a lower rate also known as just points. Points are also represented by a percentage and not a flat dollar amount. A credit can be given toward closing costs when the rate you select is above the going rate. These prices vary depending on the day and the market.
The borrower doesn’t like a 5% interest rate and wants a lower rate. We look at a 4% interest rate. The loan officer looks up the rate sheet and finds that it costs $5000 in points to have a lower rate. The borrower likes the 4% rate because it is lower and says they want the 4% rate because his neighbor was bragging about a 4.5% rate and the borrower wants to do better. Unfortunately, the borrower doesn’t even know what program the neighbor was using so there is no way of really comparing equally.
The Stone Face
The loan officer looks at the two different payments from the 4% interest rate and the 5% interest rate and find the difference between the two payments is $50. The loan officer then divides the $5000 in points by the $50 in saving and finds that it will take the borrower 100 months to recover the costs of the points. 100 months equates to just over 8 years. The loan officer lets the borrower know that it will take just over 8 years for the discount points to be worth it. The borrower then gets a stone face and the loan officer asks the borrower if they have a question.
The borrower then explains that they are moving in the area based on a 5-year contract with their employer before they are likely assigned to another location and they don’t anticipate being in the area for more than 5-6 years. The loan officer should then look at other options or interest rates that fit closer to that 5-year time frame so the borrower does not overpay on closing costs, based on the borrower’s plans, to get a lower interest rate. If the borrower kept the 4% interest rate and moved at the 5-year mark, the borrower would have lost about $1800 from trying to get a lower interest rate. The $1800 comes from the $50 difference in payment each month multiplied by 36 months, which is the number of months after 5 years it would take to recover the costs. The lowest interest rate is not always the best interest rate.
The Higher Rate May Be More Beneficial
Let’s use the same interest rate scenarios from above with a different borrower. This time the borrower is expecting to get a lump sum of cash and feels confident that they will be able to pay the home off within two years. However, in their current situation, they don’t have the ability to pay much more than their down payment and closing costs. The 5% interest rate doesn’t come with any point or credits. The loan officer, trying to find the best option for the borrower, sees if they take a 6% interest rate, they will receive a credit of $5000. The loan officer finds that the difference between payments with a 5% interest rate vs a 6% interest rate is $100.
The loan officer double checks the numbers and lets the borrower know that if they took a 6% interest rate instead of a 5% interest rate that they could give the borrower a $5000 credit toward closing costs. If the borrower plans on paying the loan off within two years, then the borrower would be paying $2400 extra over the two-year period compared to the lower interest rate. However, with the 6% interest rate, the borrower would be able to receive a $5000 credit. This means the borrower would be coming out ahead with the difference of $2600 upon paying off the home within two years. The borrower is grateful the loan officer did a little extra work to run those numbers and decides to take the 6% interest because it best fit their goals best. The lowest interest rate is not always the best interest rate.
Conclusion
Options in interest rates can be a difficult concept to understand. Experienced and trustworthy loan officers will help their clients navigate which interest rate may be best for their clients’ circumstances. Each scenario is different and needs to be treated uniquely. I commonly meet with clients and explain this to them after they have spoken with another loan officer who has not educated their client or given them options. Trust of a client should be earned and not taken for granted. I like to show my borrowers a few different rates so they know they have options. It helps me to better serve them.
It helps for the borrower to know what their future goals are and how long they plan on being in the home. By letting your loan officer know what your goals are, they should be able to better assist you. If they are not willing to give you options, it might be time to look for a different loan officer. Life always changes and rates may potentially drop, opening up opportunities to refinance. I feel the more a borrower pays to buy down an interest rate, the riskier it is that the borrower will not be able to recover the amount they spend in points. It is not logical in many cases. The lower interest rate is not always the best interest rate.