Why APR is not the best tool for comparing loans

Minneapolis, MN: I see it all the time. Arm chair financial guru’s always claim that using APR annual percentage rate is the best way to shop for a mortgage loan. While in theory, that is correct, in practice, it could end up giving you the wrong home loan.

The Federal Government requires APR to be disclosed right along side the loans interest rate as a means to help borrowers make an informed loan decision. Everyone understands the interest rate. Lower rates equal better deals and lower payments, but few people understand APR.APR Annual percentage rate

The APR takes the base interest rate, then factors in all of the following, and more; lender fees, discount points, days of interest, points to buy down the rate, and mortgage insurance (if applicable). If two lender quote you the exact same interest rate, the lender with the lower APR is supposed to be a better deal because of less costs and fees. So in theory, the lender quoting you the lower APR is always the better deal, right?

Wrong. The truth is that APR is a very poor way to comparison shop for a mortgage, because it can cause borrowers to make costly bad decisions.

APR was created to provide a way for borrowers to account for closing costs associated with the getting a mortgage loan. This sounds good in theory because it can be very confusing for home buyers to compare loans.

APR calculations are based on bad assumptions.

The first issue is APR assumes zero inflation, and that the value or buying power of a dollar today will be exactly equal to the value of a dollar 10-years,  20-years, or even 30-years from now.

Next, the APR calculation assumes that the mortgage loan will never be pre-paid or paid off early. That means no refinancing or selling the home. This is highly unlikely since the average life of a home mortgage loan is less than seven years.

Just think about your own loans: Is it rare to see the same loan in place for the full term of the loan. You only get the actual APR listed if you carry a loan fully to term.

Mortgage interest is front end loaded, meaning you pay more interest than principal in the beginning years of a loan, while towards the end of the loan, you pay more in principal than interest. So assume you got a APR quote of 4.21%. Your actual APR would only be 4.21% is you carried that loan for the full 30-years, and never pre-paid a dime.  If you sold the home after a much shorter time, your actual effective “APR” could be 15%, or even higher.

The APR calculation also does not consider the time value of the money. So if you spent a few thousand dollars buying down the interest rate with discount points, APR calculation does not give any value to the money if it wasn’t spent on closing costs.

APR does not take tax consequences into consideration. This can be significant, since higher closing costs on the mortgage loan may not be deductible, while the higher interest rate typically is deductible.

Finally, APR can also still be easily manipulated by bad lenders, making it totally worthless for real life comparisons. 

Real World APR Considerations.

I spoke earlier of two lenders giving you the same rate, and comparing APR. But what if two lenders give you different interest rates? Now comparing loans with the APR calculation is totally confusing. The lower rate will always have a lower APR, but what did it take to get the lower rate?

Let us assume a $150,000 loan. Lender A is offering a great low rate of 4.250 percent and $3000 more in points Lender B, who is offering a higher rate of 4.625 percent, but with no points. Which one is better?

The payment difference between the two interest rates is just $34 per month. So is it worth paying $3,000 in points to Lender A in order to save $34 per month? Maybe. Maybe not.

In this example, it will take a little over 7-years to break even on the additional up-front closing costs. If you are going to be in the home less than 7-years, this is a POOR loan choice. You paid more up-front than you ever saved, but you got a lower APR.  If you are going to be in the home 20-years, paying the higher cost for the lower interest rate is a great choice.  You save more in interest than it cost up front.

Many mortgage companies these days quote no origination fee loans. These lower closing costs sound great, but but they don’t really have lower closing costs, and they sure as heck are not working for free. To give you those lower closing costs, they simply INCREASE the interest rate they offer.

There is also the opposite, this is called discount points, where you pay more money up-=front today in exchange for a lower interest rates.

But wait, to make the decision even more complicated (if that’s possible), borrowers rarely take the value of to day’s dollars and cash flow into account. If you are going to be in the home 20+ year, but you don’t really have the additional $3,000 costs, now what?

How about the other direction again. Maybe you know you’ll likely be in the home 20 plus years, but you don’t really have the extra $3000, or don’t want to spend the extra money today to get the lower rate.

Worse yet is on a refinance loan, where they tease you with super low rates, but you end up financing the discount points into the loan itself… Yikes.

APR annual percentage rate

The bottom line is that you should forget APR annual percentage rate by itself to pick a loan. Instead, do simple math in conjunction with an analysis of the cost benefit of lower rate/higher costs, or higher rate/lower costs as it pertains to your individual situation and cash flow.

Any skilled professional Loan Officer can assist you with all of these calculations. We lend in MN, WI, and SD.


Use lender credits to pay closing costs

Minneapolis, MN:  The biggest challenge for most home buyers, especially first time home buyers, is coming up with the required down payment.  While most people understand down payment, they are shocked to learn their are mortgage closing costs. Wose yet, is discovering how much closing costs can add up to.

Mortgage loan closing costs cover many items, including appraisal, credit report, state deed taxes, title company costs, title insurance, lender costs, and more.  Plus you also have something known as pre-paid expenses which need to be paid too, including buying your first years home owners insurance policy, and one time pro-rated property taxes, which are based on when property taxes are due, and what month you close on your new home.

While closing costs and pre-paid items are actually separate, it is very common for people to combine both of them together, and simply say ‘closing costs’.

CLOSING COSTS ARE NOT 3%

I hear it day after day after day, that closing costs are around 3% of the purchase price. This generalized statement couldn’t be more wrong!

Closing costs vary based on many factors, including the homes purchase price, state, property taxes, loan program, and the buyers choice of how to pay for them.

This misinformation comes from the fact that conventional loans only allow for a home buyer to roll into the loan closing costs up to 3% of the purchase price.

Many loan closing costs are based on the loan amount, and the rest are the same regardless of the homes price.  For example, standard loan origination costs are 1%.  So 1% of a $100,000 loan is just $1,000, while a $400,000 loan of course equals $4,000.

Items like the appraisal may be the same for both the $100,000 home or the $400,000 home. While the cost is the same for either house, the $400 appraisal fee is 1% of a $40,000 home, but only 0.10% of the $400,000 home.

Another good example are Title Company charges. Standard Title Company closing fee is usually a flat fee, but the required title insurance varies based on purchase price.

HOW TO PAY FOR CLOSING COSTS

Mathmatically, the best way to pay for your loans closing costs will always be to pay cash out-of-pocket. Realistically, especially for first time home buyers, this makes the amount needed out of reach.

Mortgage loan programs always require you bring your down payment, but closing costs can be rolled into the loan a few different way.

  1. Seller paid closing costs
  2. Lender Credit
  3. Combination of both

I dislike the term ‘Seller paid closing costs’, as many people thing the seller is paying it, and therefore it is free. The reality is that while the purchase agreement says the seller is paying, the person actually paying is the buyer. You are just paying over time.

For example, assume the seller has listed the home for $200,000. You make a full priced offer at $200,000, but your offer also asks the seller to pay the maximum conventional loan allowed closing costs of 3% ($6,000).

If the seller says YES, many people think you got closing costs for free. But think about it.  The seller actually netted just $194,000 in their pocket. So you could have made an offer for $194,000 and paid your own closing costs. The seller got $194,000 either way, but you rolled your closing costs into the loan, opting to pay the costs over time, versus up-front today.

Lender credits is another tool. With lender credits, the lender will increase your loans interest rate in exchange for reducing your out-of-pocket closing costs today.  You can choose a small rate increase with a small lender credit, all the way to absolutely no closing costs whatsoever with a much larger rate increase.

You may also see lender credits employed in a different way too.  For example, many lenders will scream things like ‘no lender fee’, or maybe ‘free appraisal’ if you use them. All they are doing is increasing the interest rate a bit to offset normal costs – but not telling you.

The most common one we see is no loan origination options, which will generally increase a 30-year fixed rate loan by 0.25%.

ARE LENDER CREDITS GOOD OR BAD?

Increasing your loans interest rate never sounds good, but does thing make lender credits bad? Think of them as a financing tool, and your personal situation?  Do you have the cash to pay your own closing costs? Maybe you have the money, but would rather use it to improve the home.  Lenders credits might still be a good choice.

Do you not have the money? Then it may be a matter of using lender credits, or not buying the home at all. In this case, a small amount all the way to complete no closing costs via lender credits may be your sole option.

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We lend in MN, WI, and SD.  Equal housing lender. NMLS 274132

Lender credits


How to get the best interest rates or closing costs

How to get the best interest rates or closing costs probably isn’t what you think.
Minneapolis, MN: Buying or refinancing a home? What mortgage company should you work with? What lender offers the best interest rate? Sadly, so much of what you see out there is simple advertising smoke and mirrors designed to capture your attention. 
For example, did you realize you can pretty much pick any interest rate or closing costs you want on your mortgage loan?

HOW THE BEST INTEREST RATES WORK

Want a super low interest rate? No problem.  best interest rates

In many cases, you have the option to pay more money upfront in exchange for a lower rate.  Some refer to this as “paying points,” buts that’s a bit of an archaic term.  Self-annointed gurus used to say “never pay points!” But that’s not necessarily good advice.  Discount (or “discount points”) offers a perfectly legitimate and objective choice to pay more money upfront in exchange for a lower interest rate.   Whether or not the trade-off makes sense to you is fairly subjective.  

In the more intelligent conversations, discount is discussed in terms of “breaking even” or “break even months.”  In other words, if I pay extra cash today, how long will it take for me to break even due to lower monthly payments.  Closer to 10 years?  That doesn’t make sense for most people.  5 year or less, however, and it can start to make better sense.  

All this to say that the discount points required to move down to 1/8% are fairly low for most lenders at the moment.  For instance, paying an extra .5% of the loan amount could get you another eighth of a point lower interest rate, and it would take just over 4 years to break even on that extra expense.  Of course, if you plan to sell or refinance in 3-5 years, this makes no sense. If this is the last house and mortgage you want for the foreseeable future, it’s something to consider.  

Lowest closing costs

HOW THE LOWEST CLOSING COSTS WORK

A similar conversation can be had for paying less in closing costs up-front today. You can choose to pay lower closing costs today, but understand this is simply achieved by the lender raising the interest rate you would get.  Small reduction in costs equal small rate increases, while large reduction in closing costs equal large interest rate increases.

This trade off is know as ‘Lender Credits’

So again, what is the math, and does it make sense? A common lower closing cost quote is a “No Loan Origination” quote. On most fixed-rate loans, you can eliminate loan origination costs, which is 1% of the loan amount by roughly increasing the interest rate 1/4%.

On a $200,000 loan, eliminating loan origination would save you $2,000 today, but a 1/4% higher interest rate will cost you $29 more per month on that $200,000 loan. Simple math gives you a 69 month break even period. If you are in the loan less than 69 months, you win.  Each month after 69, you pay an additional $29.

What is the math calculation on your loan amount?

But wait, even this is too simple. Do you have the money today? Do you want to keep some of that money in your pocket today to use for something else? So again,  Whether or not the trade-off makes sense to you is fairly subjective. 

Lower closing costs in exchange for higher interest rates is also a perfectly legitimate tool for home owners.

THE BOTTOM LINE

Don’t fall for advertising gimmicks. Rates way lower than everyone else, you are buying discount points, but may not know it. Anyone offering ‘no lender fees’, rebates, or any other sort of reduced closing costs are simply increasing the interest rate to pay for it.

The bottom line is simply this. A good conversation with a licensed, experienced, professional Loan Officer over your long-term, short-term, payment and equity objectives, is the only way to determine what is best interest rate for you and your situation.


The closing costs are 3% myth debunked

I just heard it again, a Real Estate Agent saying average closing costs to obtain a home mortgage loan in Minnesota are about 3%.

This simply is way too broad a statement about actual closing costs.

As an actual Minnesota mortgage lender for the past 26-Years, the perception that mortgage loan closing cost are about 3% in MN has never been really accurate. This gets spread around primarily because a conventional loan only allows for seller paid closing costs of 3% ( FHA Loan is 6%: VA Loan is 4%, convention is 6% with a large down payment ).

About 1/2 of closing costs are a set cost regardless of purchase price. The other 1/2 of closing costs are based on the purchase price. Take an appraisal for example, a $500 dollars appraisal cost is about 1% of a $50,000 Loan, but only .1% of a $500,000 Loan. Another example is the title company closing fee, which is now around $400. Again, regardless of purchase price., but can make a big difference in the overall cost percentage.

So lower priced homes tend to have costs of 4% to 5% of the price, while upper end homes tend to come in closer to 2% of the price.  Therefore getting 3% seller paid costs falls short of the real costs for many buyers.  These examples assume full closing costs and pre-paid items (taxes and insurance).

To make up the difference, lender can, and commonly offer you other options, like a no loan origination cost lan, or even total no closing costs loans. We also can do something called ‘lender credits’ to reduce out of pocket closing costs. While these options sound great, they are all achieved by increasing the interest rate. Therefore you pay costs over time, versus up-front today.

That is the same when asking for seller paid closing costs. You are paying over time, versus out of pocket today.

Finally, there is absolutely nothing wrong with any of these options. They just need to be understood and analyzed to see what is best for you.  A good Loan Officer will explain and go over all these items once we see a full application, and understand your financial position, amount of cash you have to pay for down payment and more.

Property understanding all these items, then working together with a great agent to property structure your offer will make sure you get a great overall deal on your dream house.

Be sure to ask your Loan Officer plenty of questions, and be sure you carefully pick the Loan Officer who will be handling your largest financial transaction of the average persons life.

If you are buying a home in Minnesota, Wisconsin, or South Dakota… I can be your Loan Officer.  Contact me at (651) 552-3681 or JoeMetzler.com.

 


What are mortgage loan closing costs, and why do I pay them?

Home buyers, especially first time home buyers, commonly fail to understand all the costs involved in buying a home.  Everyone understands down payment, so no issues there. But mortgage loan closing costs are a whole different story.

I often hear potential home buyer comment that they thought they had saved enough for a down payment, only to be blind sided with mortgage loan closing costs.

WHAT ARE MORTGAGE CLOSING COSTS?

All mortgage loans have closing costs. They include appraisal, credit report, state taxes, title company fees, loan origination fees, state deed taxes, and more.  You also have what is known as pre-paid items, which include pro-rated property taxes on the house you are buying, and paying for the first years home owners insurance up-front.

Actual closing costs and pre-paid items can easily range from about 2% to 8% of the sale price of a home, depending on where you live, and the purchase price of the home.

Your Loan Officer will provide you with a detailed estimate of these closing costs based on the actual home once you pick it out, and can give you a good ballpark number during your initial loan review.

TIP: Anyone telling you closing costs are always a certain percentage is flat out simply wrong.

HOW TO PAY CLOSING COSTS

Yes, closing costs can really add up.  If you were planning on a 10% down payment, this means you really need 12% to 18% of the purchase price of the home.  Yikes.

The good news is, the mortgage industry understands this, and allows you to pay closing costs multiple ways.

Option 1) Pay cash out of pocket. Always the best move, but incredibly burdensome for most home buyer.

Option 2) Seller paid closing costs. You simply ask the seller to pay your closing costs for you when making your offer. Depending on the loan program you are using, the seller can pay between 2% and 6% of the purchase price in closing costs on your behalf. While this sounds free, because the ‘seller’ is paying them for you, the reality is the seller isn’t paying anything. Rather, this is a method of you rolling the closing costs into the loan itself.

For example, the seller is asking $200,000 for the home.  You offer $200,000 – but also ask the seller to pay $6,000 of your closing costs. If the seller agrees, many people think they just got free money.  The reality is the seller has accepted $194,000 in their pocket. So you could have bought the house for $194,000, and paid your own closing costs.  Instead you are buying the house for $200,000, and paying closing costs over time, versus out-of-pocket today.

It is a little more obvious to buyers that they are paying over time, when the same seller who wanted $200,000 refuses to budge, but you need closing costs rolled in to lessen your out-of-pocket burden. In this case, you’d restructure your offer to $206,000, and have the seller pay the $6,000 of closing costs.  The seller gets what they wanted, and you rolled closing costs into the loan, again paying over time instead of out-of-pocket today.

Option 3) Lender Paid Closing Costs (also known as Lender Credits). Under this option, the lender will reduce your actual real closing costs by increasing your interest rate. You can choose to increase your interest rate a tiny amount, for a tiny reduction in closing costs, all the way to completely eliminating all of your closing costs with a much higher interest rate.

This isn’t a good or bad option, rather it is a depends option. How much reduction do you need? Do you have all the closing costs money today? How much higher will the payment be?  How long will you live in the home?

TIP: ALL LENDERS HAVE ESSENTIALLY THE SAME TRUE CLOSING COSTS. When shopping lenders, many people will receive a closing cost quote lower than someone else, giving the illusion of a better deal. Many banks and lenders claims things like they give free appraisals, or never charge loan origination fees. No closing cost loans were all the rage a few years ago.

Little do many people realize that all these lenders are doing is increasing your loans interest rate to cover these items, but not telling you they are doing it. They don’t work for free, and someone has to pay the appraiser.  This lower closing cost ploy makes unsuspecting home buyers potentially pick a lender based on a perceived better deal, when in fact, it isn’t. You pay, you always pay. How do you choose to pay? Lower rate = higher costs.  Higher costs = lower rates.

Option 4) Any Combination. This is actually the most common way people pay closing costs. Many ask the seller to pay some, maybe increase the rate 1/8 or 1/4% to pay some, and maybe a little bit out-of-pocket to pay the rest.

CLOSING COSTS – THE BOTTOM LINE

It is very common for many home buyers through these options, to completely eliminate closing costs as an out-of-pocket expense, leaving them with just needing their down payment to buy the house.

So don’t ever let the fear of closing costs keep you from buying your dream home.