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Financing 101: Part II

Posted by Greg Moser on August 13, 2015
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Should You Pay Points?

You can buy down your mortgage for the first few years by paying a lump sum to the lender. But unless the seller or somebody else is paying this fee for you, it doesn’t make much sense to buy down your own mortgage. You can sock away the money in your own savings account and use that money every month, on which you earn interest, to help pay your own mortgage payment.

Points will decrease your interest rate. Each point is equal to 1% of your loan. To recover the cost of those points, figure out the monthly savings with the lower interest rate versus the rate without points. Then divide that number into your points to arrive at the number of months it will take you to break even. Everything after that is gravy.

For example, say you are paying 2 points on a $200,000 loan to get an interest rate of 5% with a payment of $1,074. Or you could get that $200,000 loan at an interest rate of 6% without points and pay $1,200 per month. The difference between the two payments is $126.

Two points will cost $4,000. To recoup that investment, $4,000 divided by 126 equals almost 32 months. By your 33rd month, after almost three years of payments, you will begin to profit from paying those points.

Collection for Taxes and Insurance

If you are considering a loan that is higher than 80% of the purchase price of your new home, you will likely be asked to pay monthly property taxes and homeowners insurance to your lender. Your lender, in turn, will pay the tax assessor and your insurance company. In this case, your monthly PITI will change from year to year as annual taxes and insurance go up or down.

  • Lenders will also collect a reserve, from 2 to 8 months of taxes and insurance, in advance from you.
  • This impound account reserve (sometimes referred to as an escrow account) will increase your closing costs.
  • The reserve amount collected depends on the time of year and when your annual tax bill is due.

Even if you are putting down 20% or more of the purchase price, often lenders will charge “1/4 point to rate,” meaning you will pay .25% more in interest NOT to set up an impound account. Personally, I prefer to be responsible for paying my own taxes and insurance.

Prepayment Penalties

As a hedge against interest rates falling, lenders who make fixed-rate mortgages will sometimes demand a loan feature known as a prepayment penalty. This means if you pay off the loan within a certain number of years, typically one to five years, you will also pay the lender an additional six months of interest, or more

What are Mortgage Rates Based On?

The only correct answer is Mortgage Bonds or Mortgage Backed Securities. Mortgage rates are not based on the 10-year Treasury Note. When shopping for a new home loan, many of you will jump online to your favorite financial web site to see how the 10-year Treasury Bill is doing. In reality mortgage-backed securities (MBS), cause mortgage rates to fluctuate. In fact, it is not unusual to see them move in completely different directions and, without professional guidance, that confusing movement could cause you to make a poor financial decision.

Don’t feel bad, I have seen many bond market reporters mistakenly tie mortgage rates to the performance of the 10-year T-Bill. Many of these financial reporters possess a broad knowledge of bond markets, but they are not mortgage experts and do not fully comprehend how mortgage interest rates are determined.

My suggestion is to avoid working with lending professionals who keep their eyes on the wrong indicators.

The Fed Lowered Rates — Why Aren’t Rates Going Down?

When the Fed lowers the short-term discount rate, this is designed to stimulate consumer spending on short-term credit, which affects credit card rates, some car loans and lines of credit. The short-term discount rate has little affect on long-term mortgage rates.

Think about this: the market moves faster than you may expect — sometimes at lightning speeds. When investors spot a short-term stimulus, they bail out of the safe haven of bonds (or mortgage backed securities) and move those dollars into stocks. When this happens, we see a rally in the stock market and a sell-off of mortgage backed securities, both of which cause interest rates to go up.

We have all heard the radio commercials from lenders: “The Fed is at is again — slashing rates. Don’t miss this opportunity to get the lowest rates in years! Call us today, before it’s too late!” We even hear it on the nightly news: “Fed set to cut rates again. This action will help to stimulate the housing market”.

They aren’t necessarily lying to us, but they are being disingenuous by implying that mortgage rates are going to follow suit and fall. Don’t fall for the hype. It’s a ploy. They figure if they say something is true long enough, people will start believing it. It makes the phone ring, and that’s all that matters to many of these lenders, some of whom, I may add, are teetering on extinction.

The Reality of Fed Rate Cuts

When the Fed cuts the rates, especially by a large or repeated percentage-point drop, people automatically assume that mortgage rates will fall. But if you follow mortgage rates, like I do, you will see that most of the time, the rates fall very slowly, if at all. Historically, when the Feds have dramatically cut rates, interest rates remain almost identical to the rates established months before the cut as they do months after the cut.

The Fed’s moves aren’t totally irrelevant and do have a delayed and indirect impact on home loan rates. When investors worry about inflation, this concern will push rates up. When Congress wants to stimulate action and raise money for a deficit, it will create more U.S. Treasuries for folks to buy. This added supply of new Treasuries can also cause rates to move higher.

Even more crucial is when a buyer is in the process of making a decision whether to lock a loan just before a Fed rate cut. Say a buyer is in contract and thinking the Fed is going to lower rates next week. The buyer might be tempted to wait before locking the loan (big mistake). Well, when the Fed makes that big drop, say by 50 basis points or more, it actually can cause 30-year-fixed rates to initially spike. But then over time the rates generally level out or regain their losses — depending, of course, upon current market trends. So, if my buyer is within three weeks of closing before an anticipated Fed cut, I usually recommend locking ahead of the Fed rate cut to protect that original good interest rate.