“What is the interest rate these days?” That is a question I’ve heard for the past 15 years while working in the Mortgage industry. Interest Rates will vary greatly based on your personal finances and credit history, as well as the type of loan you are getting. It’s a good question but it only gives you half of the answer.
A better question is “What are my rate options and what is the price?”
By the end of this article, you will know:
Discount Points, Lender Credits, and Par Rates.
How to compare interest rates from one lender to another.
How to use this information to make better Mortgage decisions.
The Price
Every Lender or Broker can give you a range of interest rates. Each interest rate offered has a different price associated with it. This is generally displayed on a rate sheet, which outlines your interest rate and pricing options. The table below is a basic example of a rate sheet. On the left side we have the interest rate, and the right side is the price. The price is a percentage of your total loan amount that can either increase your closing cost or save you money.
On the example rate sheet above, a 5% interest rate will cost you 1% of your total loan amount and it will be part of your closing costs. When you pay extra to get a lower interest rate, it is called Discount Points or Rate Premium.
A 6% interest rate will give you 1% of your total loan amount as a credit that can be applied to your closing costs or even cash in your pocket. When the lender pays you to take a higher interest rate, it is called Lender Credit.
The middle-rate of 5.5% has a price of 0% so you will not pay extra or receive credit. The Par Rate is the interest rate that has a price closest to zero. The Par Rate is very useful to compare interest rates from different Lenders and Brokers because it levels the playing field and gives you the best idea of the true cost.
Comparing Rates
Let’s say you are shopping Mortgage interest rates from two Brokers. Broker A quotes you 5% interest rate and Broker B quotes you 5.25%. Which is the better deal? You may think 5% is better, but we don’t have the full picture yet. Let’s look at the rate sheets.
Broker A quoted you their lowest interest rate, but you will pay 1% of your total loan amount at closing. Broker B quoted you their Par Rate, which costs you nothing. If you want to compare apples to apples, you need to look at the Par Rates of each Broker. When you compare the Par Rates of each Broker, you will find that Broker B has the better price.
It’s also important to note you aren’t stuck with the rate that the Broker quotes you. You can go up or down the rate sheet depending on your need.
Here are some dynamite questions to ask when you are shopping rates.
What is your Par Rate?
How much does it cost to buy down the interest rate?
Can you give me a few options in writing?
Discount Points or Lender Credits; which one is right for me?
Now we know Discount Points, Lender Credits, and the Par Rate. And we can also accurately compare rates from multiple lenders to find out who is offering the best price. How do you know which interest rate is the best one for you?
Let’s take this same rate sheet as above and start putting some real numbers into context. This is a $300,000 loan amount with a 30-year term.
This is the part where we are going to do some math. I apologize for not warning you earlier, but if I told you math was involved in the beginning you probably wouldn't make it this far. Dust off that TI-83 sitting in the back of your everything drawer or open your calculator app and follow along as we compare the 5% and 6% rate options.
Difference in monthly payment: $189 1,610 – 1,799 = -189
Difference in price (up-front cost): $6,000 (-3,000) – 3,000 = (-6,000)
Months until the 5% rate saves money: 32 (6,000 / 189 = 31.74 months)
The 6 % rate will cost you $189 more per month but you will walk away from closing with $6,000 more in your pocket when compared to the 5% rate. That means it will take 32 months before the 5% rate saves you money.
Everyone’s situation is different but the general rule to follow is:
Discount Points are great to pay when you plan on keeping your home (and interest rate) for a long time. Higher Cost up front, savings in the long run.
Lender Credits are great when you don’t plan on keeping your home (and interest rate) for a long time. Lender Credits are also very helpful when you don’t have as much cash available to cover closing costs. Savings up front, higher cost in the long run.
Knowing the different pricing options available to you and how they work is essential any time you are shopping for a mortgage. Your Mortgage Broker should discuss your specific situation and goals, present you with relevant rates and products, and provide you with long term cost-analysis of your choices. The next time you hear “zero closing cost loan” you should know that you are paying for it with a higher rate and that the Lender Credits are covering the closing costs so you don't have to pay out of pocket.
In summary, the interest rate is only half of the picture. A price will always be associated with an interest rate. You can choose your Interest Rate and Price strategically to save you money.