When my daughters ask me what I do all day, my answer is simple: I talk about rates.
“But Daddy,” they ask, “isn’t that boring?”
The answer is absolutely not. Rates are never, ever boring, especially when you’re looking for a loan. But a loan rate is probably the most confusing topic to talk about, particularly when you’re not a mortgage banker like me. So that’s why I find myself having the rate conversation with my clients more than any other these days.
When I started in the mortgage business in 2000, the lending market was quite different than today. When someone said, “what’s today’s rate?,” I could answer with conviction in a matter of minutes.
That’s because credit scores, down payment, debt to income ratios, and property type did not matter. As a result, “The Rate” did exist, and could easily be quoted. The government agencies (Fannie Mae and Freddie Mac) both priced every loan the same way. In fact, the common complaint at the time came from the better credit borrowers, since they’d often ask me (and I quote): “Shouldn’t I get a better rate for having such good credit?”
Then 2007 happened.
Quickly, lenders realized that credit risk should play a role in mortgage pricing. Sure, it sounds obvious today, but back then it turned the mortgage world upside down. The pain of managing a massive foreclosure crisis had lenders scrambling. It didn’t take long for lenders to realize that when a borrower had more equity and better credit scores, they were less likely to default. Now, that wasn’t completely the case because Strategic Defaults became common, but a pattern existed nonetheless.
This is when Loan Level Price Adjustments (LLPAs) from the agencies were created.
How Rates and Points Really Work
The LLPA is a complicated matrix that blends various credit scores and down payments to come up with the total “points” to charge for the best available rate. For instance, if the best zero-point rate on a given day was 4.25 percent, you would actually be charged one point if you had a 719 credit score on a five percent down mortgage. Check out this chart:
With today’s high prices and tight cash constraints for first time homebuyers, not many people pay points or up-front fees. We help clients analyze that decision, but generally speaking, your money is probably best invested elsewhere rather than paying down your mortgage rate.
So what if this borrower (719 credit score, 5 percent down payment) didn’t want to pay, or have the funds, for that one-point premium? The only option is to take a higher mortgage rate.
If you could look into a lender’s pricing portal, you would see rates ranging almost 1.5 percent, from high to low. For instance, as I write this, my conventional mortgage rate sheet starts at 3.75 percent and ends at 5.25 percent. The lower the rate, the higher the cost for the borrower; the higher rate, the more profit that exists, which is used to help absorb the price adjustments (LLPAs). In general, one point is roughly .25 percent in rate.
Is it worth it to pay points?
To put real money to work, let’s say you have a $350,000 mortgage.
Your options are to take the rate of 4.25 percent ($1,721/month) paying a $3,500 (1 percent of the loan amount) fee to the lender OR a rate of 4.50 percent with a payment of $1,773 with no upfront fee.
The question for you is whether you would rather have $3,500 less cash after you buy your home, or pay the extra $52 per month.
If you think about it, you would have to save $52 per month for 67 payments (5.5 years) to have the better rate make sense. Sure, it’s a bit more complicated than that due to tax savings of the higher rate and enhanced principal pay down with the lower rate, but this quick math shows the general principal. If you’re not planning to live in the home for five years or more, there’s an obvious argument to be made about not paying points.
In the end, it’s never just about “the rate”
LLPAs do not just stop at credit score and down payment; other factors play a role in pricing such as:
- Property Type – condo vs. single family vs multi-unit
- Subordinate Financing – loans where a second mortgages exist
- Transaction Type – cash-out refinance vs. rate/term refinance
- Adjustable Rate Adjustments
- Occupancy Type – investment property, owner occupied, second home
That’s why figuring out “The Rate” is really all about about you. What you are trying to finance? How do you intend to use the property? What down payment structure do you plan to use? Since your situation will always be unique, you’ll want to talk about all of these details and scenarios before making up your mind which mortgage is right for you.
As always, if we can help you sort out the details and run the numbers for you (whether you’re buying or refinancing), give us a call at (202) 899-2600. We’re here to help.