Understanding The True Value Of A Lower Mortgage Rate

A couple of weeks ago I published a guest post on using APR to shop for a mortgage. In short…it gets complicated. One of the more challenging aspects of analyzing different mortgage options is figuring out the tradeoff between the up front fees and the mortgage rate. In other words…are you better off with lower fees and a higher interest rate or higher fees and a lower interest rate?
If you thought the APR discussion was complicated this gets even more complicated and we didn’t want to get into all the details in that particular post. So I thought I would revisit the issue today. Here are some of the key points:

  • It’s not as simple as looking at the difference in the monthly payments and adding them up. Two different rates result in different principal repayment schedules and you have to factor that in also.
  • You have to factor in how long you are likely to keep the loan because the vast majority of mortgages are refinanced or paid off (e.g. property sold) in only a few years.
  • You have to factor in the time value of money – i.e. one dollar saved today is worth more than one dollar saved tomorrow

To figure out the dollar savings from a lower rate I actually had to create a spreadsheet with multiple formulas. If I want to run the analysis in reverse – how much of a rate reduction is required to offset lower up front charges – I actually have to use Excel’s goal seek functionality.
So, let me give you an example using the following base case: you are buying a $400K home with 20% down and looking at a 3.75% 30 year amortized mortgage that will be kept for 5 years (a reasonable assumption from what I’ve read). Now, another lender comes along who can save you 1/8%. That’s worth $1736. So basically the first lender needs to come in with $1736 in lower up front costs to be competitive with the second lender.
On a related note you can use this same methodology to figure out if it’s worth buying down the rate on your mortgage. Well, actually you can’t because you don’t have my spreadsheet 🙂 But in the example above if you could buy the rate down by 1/8% for no more than $1736 it would be a good deal.
So you don’t have my spreadsheet but you might be able to get close enough by running the two amortization schedules side by side and adding up the interest savings over time. Of course, to really do it right you would need to discount the savings over time. But simply adding them up might get you close enough if the time frame is short enough. It’s better than just winging it.
#MortgageRates #Mortgages
Gary Lucido is the President of Lucid Realty, the Chicago area’s full service real estate brokerage that offers home buyer rebates and discount commissions. If you want to keep up to date on the Chicago real estate market or get an insider’s view of the seamy underbelly of the real estate industry you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.

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