Imagine getting a $55,077 mortgage credit rather than paying a mortgage fee to get a new loan. A $55,077 mortgage credit was what I was quoted for a $4.125 million, 10/6 ARM at a 3.625% rate. Surely receiving a large credit is better than paying a mortgage fee right? Not necessarily.
The higher the mortgage rate you are willing to pay, the greater the mortgage credit you receive. The reason is that the lender is making a higher interest rate spread off your loan.
Taking out a new mortgage at a lower 3.375% rate with only a $3,514 credit might be a more optimal decision for a well-qualified borrower. By saving $576 a month in mortgage payments, you will break even in 89 months.
You get 89 months by taking the difference in the credit of $51,563 and dividing it by $576. If you plan to hold the mortgage for longer than seven-and-a-half years, then you will come out ahead all things being equal.
This is the traditional argument for why getting a lower mortgage rate with less credits may be better. However, there is another argument for why paying a small mortgage fee is better than getting a large credit. And I’m not sure most people know this.
Why It May Be Better to Pay A Mortgage Fee Than Receive A Credit
Curiously, I learned from a Citimortgage officer you may not receive the entire mortgage credit, especially if it more than covers all fees. Instead, some or most of the credit may be wasted. As a result, it may be better to choose a mortgage rate that comes as close to a no-cost mortgage as possible.
Follow this dialogue to understand why paying a mortgage fee may be better than receiving a credit. I asked the Citimortgage officer to clarify his rate snapshot.
Excess Credit Stays With The Lender
Me: A $55,077 credit looks so juicy if I go with a 3.625% mortgage rate. If the fees are still $11,955 for a 3.25% mortgage rate, would I get a $43,122 cash credit ($55,077 – $11,955)? Or would I actually get the full $55,077 credit after all fees? If not, where does the credit go? To a lower loan amount? Or cash back in my checking account?
Mortgage officer: In “theory” you could get that credit, but there is a restriction that the credit must cover “hard” / “legit” / “real” closing costs. Anything over that would stay with the lender. So in the real world, the way we would structure it would be to have a credit that came closest to but does not exceed the total closing costs.
In this case it would be the 3.375% note rate with a $3500 credit, meaning there would remain $14,000 and a bit of closing costs as the total cost to take out the loan would be a bit over $17,500. If you took the 3.5% note rate with the $29,000 credit, it would pay 100% of your closing costs. However, you would be leaving $11K to the bank as the costs are only $18,000.
Mortgage Credit Doesn’t Get Applied To Reducing Mortgage Amount
Me: Got it. Would the remaining $11,000 credit balance on taking out a 3.5% note with a $29,000 credit be used towards lowering my mortgage balance by $11,000? If not, do I really just lose that remaining $11,000 of credit?
Mortgage officer: No, the “credit” would not go to reducing the loan amount. It is a total loss if it is not applied to closing costs. Even though we refer to the credit in terms of dollars and cents, it is more of an accounting measurement rather than “real” dollars and cents. It is a way for us to “price” the different note rates.
The notes at higher rates are more “valuable” but not so much in hard dollar terms. The intrinsic value is obtained by providing the customer with a range of options.
I would suggest you take the 3.375% in this situation. Usually, the dollar amount difference between note rates is not this extreme, but this is a large dollar amount loan, so minor rate differences result in huge differences in amounts of credits or points.
BTW all of these figures are hypothetical as the rates are old. When it comes time to lock rates, we might land at a place where we could cover, let’s say, 80% of the closing costs without “leaving money on the table.”
Paying A Small Mortgage Fee Is Better
It’s hard to qualify for a new mortgage or refinance nowadays. Lending standards have become incredible strict since the previous financial crisis. However, if you are able to get a mortgage, then paying a small fee is better than receiving a large credit.
Ideally you want to choose a mortgage rate that provides just enough credit to cover 100% of the cost to take out a mortgage or refinance a mortgage. Every dollar of mortgage credit you receive above the mortgage cost is wasted.
The next best thing is if the mortgage credit can cover at least 70% of the cost of the mortgage. Even if you have to pay thousands of dollars at closing, at least you are paying a lower mortgage rate and are not wasting money.
Even if you have to pay even more in mortgage costs, you may eventually still end up ahead if mortgage rates stay at the same level or increase and you hold onto your mortgage for a long enough time period.
Banks Will Always Profit Off Your Loan
Please know there is no free lunch when it comes to taking out a new mortgage or refinancing your existing one. The bank will find a way to make money off your loan. Further, it won’t reveal exactly how much money it will make off you.
A good lender will give you various mortgage rate and fee options. From there, it’s up to you to decide which rate with which fee structure best suits your situation. If you are unsure about anything during the process, please ask your mortgage officer for clarification.
In the past, I would always try to get a “no-fee” mortgage. Now, if I ever get another mortgage, I will aim to get a “little-fee” mortgage to ensure fewer dollars goes to waste.
Readers, do you have any insights on mortgage fees? What do you think is the best way to minimize refinance or new mortgage costs while getting the best rate? Please always ask your lender what happens to the credit overage.
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