I get asked a lot of questions about interest rates – why wouldn’t I? I’m a loan officer. The problem is that interest rates don’t tell the whole story, neither does APR. I’ll attempt to sort out the issues and – BONUS – help you understand when it’s good to buy the rate down or, conversely, when it’s good to have the lender pay some closing costs by accepting a higher rate. I’ll start with interest rates.
Mortgage interest rates are determined by mortgage bonds which are actively traded. Rates and bond prices move inversely to one another, which is to say that when investors are buying bonds and pushing prices up, rates go down. Conversely (and somewhat obviously then), when investors decide to sell, prices go down and rates go up. This is why rates move but it’s not why they are what they are. Without going into much detail, rates are calculated by the amount of the coupon on the bond (as of this writing, the FNMA benchmark bond is the 3.5, which means the coupon rate for the bond is 3.5%). The coupon along with the price of the bond is what determines the base rate.
FNMA and FHLMC use loan level pricing adjustments (LLPA) to more accurately price loans based on certain risk characteristics. The adjustments include:
- loan-to-value: 97%, 95%, 90%, 85%, 80%, and so on,
- loan purpose (purchase, no-cash-out refinance, cash-out refinance),
- Property type: SFR, condo, townhome, 2-4-plex, etc.,
- Occupancy type: primary, second home, investment property,
- Credit score – usually in increments of 20, ie 680, 700, 720, etc.
A cash-out refinance at 80% loan-to-value will have a rate that’s about .25%-.375% higher than a non-cash-out loan at the same LTV. If the LTV of the non-cash-out loan is 75%, the disparity in rate is even wider. A purchase mortgage for an investment property at 80% LTV has the following LLPAs: I just ran a test through the pricing engine and a 720 FICO score borrower putting 20% down on an investment property had a 3.375 point loan level pricing adjustment for the occupancy type at 80% LTV and a .75 point pricing adjustment for a FICO score of 720-739 with an LTV of 80%. If the FICO score was 740 in this scenario, the LLPAs improve by .25 points for the FICO adjustment but stays the same for the occupancy. If the borrower’s score is in the 680 bucket, here’s what happens: the FICO adjustment is now at 1.75 points in addition to the 3.375 for the occupancy adjuster.
There are so many different scenario combinations between a borrower’s property type, occupancy, loan purpose, credit score and loan-to-value that a generic rate on a billboard or a radio add just doesn’t do the complexities of the situation justice. Not to mention, it commoditizes what a good loan officer does. Rather than just selling a rate, a good loan officer understands the financial ramifications of a good mortgage plan vs. a bad one. Financial concepts including the time-value of money and the Rule of 72 are important things to understand so that the borrower can make an informed choice regarding their mortgage and their financial goals. Is a 15-year mortgage better or worse than a 30-year mortgage? Should the borrower pay extra each month to pay the loan off early? These and other questions are not easily answered without thoughtful consideration as to the borrower’s current financial situation and their goals.
APR and Mortgage Insurance
The APR is supposed to take into consideration the actual costs of getting the loan such as most lender fees (some 3rd party pass-through fees aren’t included in the APR), some title fees, and the big one other than interest rate is mortgage insurance. Mortgage insurance is an annual rate that is calculated into a monthly payment (unless the borrower opts for a single-pay option). There are several factors that determine the mortgage insurance rate on a conventional loan (the rate on an FHA loan is 1.75% for the up-front mortgage insurance premium – UFMIP – and almost without fail it is .85% for the annual portion unless a bigger down payment is made). The two biggest factors in determining the rate for mortgage insurance on a conventional loan is loan-to-value and credit score. Other things that impact the mortgage insurance rate are the state the property is in, how many borrowers there are (2 is better than 1), loan purpose, loan term, amortization type (fixed vs. variable), and debt-to-income ratio, among a few other things.
Here are a few scenarios to provide some context – 30-year fixed-rate, $300,000 purchase, with a 40% DTI:
- 97% LTV (lower than FHA’s down payment requirement):
- 680 FICO – 1.07% – $267.50/month or 3.47% on a single-pay option for $10,410
- 700 FICO – .86% – $215/month or 2.98% on single-pay option for $8,940
- 720 FICO – .74% (less than FHA’s) – $185/month or 2.55 on single-pay option for $7,650 – better option than FHA
- 740 FICO – .57% – $142.50/month or 1.99% on single-pay option for $5,970 – much better option than FHA
- 95% LTV:
- 680 FICO – .85% (same as FHA) – $212.50/month or 2.76% on single-pay option for $8,280
- 700 FICO – .68% – $170/month or 2.36% on single-pay option for $7,080
- 720 FICO – .57% – $142.50/month or 2.02% on single-pay option for $6,060
- 90% LTV:
- 680 FICO – .57% – $142.50/month or 1.88% on single-pay option for $5,640
- 700 FICO – .48% – $120/month or 1.65% on single-pay option for $4,950
- 720 FICO – .39% – $97.50/month or 1.38% on single-pay option for $4,140
The other thing to remember when it comes to mortgage insurance is that the annual MI on FHA loans is for the life of the loan where as the MI on conventional loans is required to be canceled when the loan balance hits 78% of the original purchase price.
Here’s the SNEAKY thing about APR: it’s easy to quote a low APR since you don’t have to disclose on your billboard or other medium any cost to buy the rate dow to get the quoted APR. For instance, let’s say the par rate is 4.5% and that the borrower is putting down 20% so there is no mortgage insurance. The APR (without title fees) is 4.671%. A lender could advertise a rate of 4% with an APR of 4.339% (2 point cost = $6,000) but you probably wouldn’t know about the buy-down cost until you are well into the process and most buyers probably couldn’t afford that so finding out the actual rate is .5% higher (in this scenario) is a bit of a shock and misleading.
When Should You Buy the Rate Down?
Like many things in lending, this is a very individually specific decision. However, here are some general rules of thumb with regard to buying the rate down. I’ll assume the average cost of a buy-down of .5 points per .125% reduction in rate which means .005*$300,000 loan amount = $1,500 in cost. The monthly savings for ever .125% in rate reduction is just under $22 which makes the break-even point: $1,500/$22 = 68.1818 or 5 years 8 months. This is about the break-even point anytime you have a cost of .5 points to reduce the rate by .125 regardless of loan amount. The other thing that is important to understand is that typically, the further away you get from the par rate (no cost / no credit), the steeper the curve gets, ie, .75 points per .125% in rate reduction and on up. With these things in mind, here are my general rules of thumb for buying down the interest rate on your mortgage:
- If rates in general are at long-time lows or near historical lows, buy them down as much as possible – usually easier to do on a refinance than a purchase, but do what you can with one exception (see below);
- If someone other than the borrower is paying for the closing costs (any combination of the seller, Realtor, and lender) and you have money left over after paying the closing costs, buy the rate down as much as the money you have allows – regardless of how long you plan to be in the home;
- If the current rate with no buy-down put’s your debt ratio just above where you can qualify, then if you can, buy the rate down enough to get your debt ratio in line with underwriting guidelines;
- If the cost to buy the rate down is well below average (on rare occasions I’ve seen .125% reductions cost .25 – .3 points), take advantage of it because the break-even point is much shorter when the cost is considerably less;
- EXCEPTION: regardless of what the rates are, if you are fairly certain that you won’t be in the house for more than 5-6 years, it doesn’t pay to buy the rate down unless you have a scenario like #4.
My Mind is About to EXPLODE!!
I know this is a lot of information. I think it’s important for Realtors and borrowers to understand it to some extent but in the end, an expert like myself will help you navigate all of these things and provide recommendations based on your situation. Ultimately it’s up to you to make what you think is the best decision for you.