Preferred Financial

One of the initial questions we ask our clients is “How long do you expect to live in your home?” The answer is important for a variety of reasons. First, if your expected term of occupation is relatively short, say three to seven years, perhaps the borrower should be considering an intermediate ARM loan. ARMs typically have rates lower than the more traditional 30 year mortgages (click here for more information on “Intermediate Arm Loans”). Second, if the expected term is shorter than the time it will take to recover any costs you pay to buy down an interest rate, it makes no sense to pay for a lower rate since you would never recover the costs (click here for more information on “Should I buy down an interest rate?”). However, if that expected term is greater than the payback time, the decision making process changes.

For the mathematically minded, in theory, if you are planning to reside in your property for a term longer than the payback period you should buy down an interest rate regardless of the costs. Yes, regardless of the costs…..a two point loan, a three point loan, a four point loan, etc. …..yep, regardless of the costs. Remember, this is the theory that supports paying any amount for a lower interest rate if you receive that amount back before the expiration of the loan term.

To better understand this concept, let’s have a look at two charts. First, we’ll look at a wholesale lender rate sheet and then at an 18 month history of rates.

Let’s focus on three rates for demonstration purposes, namely 4.875%, 5.500% and 6.125%. Generally speaking, these rates as of 5/3/05 would represent a four point loan, a one point loan and a no cost loan respectively. The cost differentials, monthly payment differentials and the payback periods are shown below.

This chart illustrates the lender cost differential between a no cost rate of 6.125% and the other rates. That is, if you elected 5.500% rather than 6.125% it would cost you the difference between <$5,908> and $ 413, or $ 6,321. Additionally, if you chose 4.875% rather than 6.125%, it would cost you $ 16,478.

The next chart illustrates the payback period for the borrower who elects to buy down an interest rate from the no cost rate of 6.125% and either 5.500% or 4.875%. Remember, the money used to buy down the interest rate is no longer available for the borrower’s use; we take into consideration the time value of the cost differential by adding this amount to the no cost loan amount.

Once again, in theory, if you expect to remain in your property for more than 88 months, it makes sense to pay the extra $16,478 necessary to buy down an interest rate from 6.125% to 4.875%. Whoa! That’s a lot of money and the only way it is returned is if you stay for the entire payback period. In other words, you begin to recognize the benefits of this buy down in the 89th month. If you payoff that loan for any reason whatsoever before the 88th month, you will be leaving some money on the table. Let’s see just how much:

Remember, you begin to benefit in the 89th month, so if you pay off the loan after 10 years (120 months), your dollar benefit would actually be $5,990.72 rather than the losses referenced above.

Clearly, one of the primary risks of paying for an interest rate buy-down is determining the length of time you will have the loan. While your intentions might very well be that you will reside in the property for a long period, there are a variety events and reasons for this to change. A few of these events or reasons are highlighted below:

Regardless of the likelihood of one or many of these events occurring, the possibility certainly exists. Hence, we typically advise that a borrower draw the line as to how much to pay for an interest rate buy down. While, in theory, the maximum dollars should be paid for a buy down that will result in a payback sometime before the expiration of the loan term, we rarely advise even a two point loan, thereby minimizing the total dollar exposure you have during the payback period.

Another reason to minimize the amount you pay for a loan is the possibility that rates will be lower sometime in the not too distant future. Years ago, the interest rate market was considered to be relatively static. That is, while rates constantly change in the current environment, the changes occurred slowly in the past. Now, due in large part to a very sensitive worldwide economy, it’s not uncommon to see substantial interest rate swings over a relatively short period of time. Our trade deficit, budget deficit, the price of oil, terrorist threats, inflationary concerns, consumer confidence, consumer spending and unemployment rates are only a few of the variables impacting interest rates on a daily basis.

To better illustrate this volatility in the interest rate market, we have prepared a chart that looks at interest rate pricing over an approximate 18 month period:

18 MONTH HISTORY OF RATES

RATE SHEETS: 1/2/04, 6/1/04, 12/31/04, 3/31/05 & 5/3/05
WFHM

This chart illustrates that as of 1/2/04, a 5.75% rate was available at no cost. Five months later, on 6/1/04 a borrower would have had to pay $11,068 for the same rate of 5.75%. At the end of 2004, that same rate of 5.75% was available to a borrower for a total cost of only $1,491.

Another way of putting this volatile interest rate scenario into perspective is to consider the borrower’s interest rate options as of 6/1/04. While there were a wide variety of rates available for our purposes, let’s limit them to two, 5.750% & 6.375%. The 6.375% rate was available at “no cost” while 5.750% would have cost $11,068, as illustrated in the chart above.

As our discussion about the debate over “no cost” loans comes to an end, keep this in mind: it should make no difference to the mortgage broker whether you choose a two or three point loan or a no cost loan; the broker’s fee should remain the same regardless of your choice. It does at Preferred Financial. We hope this discussion has provided you with a better understanding of the issues within the debate. Now you can be the judge:

Is a “no cost” loan a fraud or is it the next best thing since twin turbo Porsches?

See ya!