0% origination fee — deal? or no deal?

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A good faith estimate with 0% origination fee? or the guy on the radio who promises a loan with no closing costs? There is just really one question to ask (dramatic pause) . . .

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Deal . . . or no deal?

In shopping for a mortgage, one of the first things that you should understand is that there is a direct correlation between the $$ amount of closing costs you will pay and the interest rate that you will receive. The higher the closing costs, the lower the rate. The lower the closing costs, the higher the rate. This truth is fairly obvious when comparing origination fees and discount points on competing options from different companies. In the newspaper for example, if you find the lowest interest rate in the Sunday rate-finder section, and move across the row to the right, you will find that the listing with the lowest interest rate has the highest origination/discount points. (1% origination or 1% discount point is a cost of 1% of the loan amount. For example, on a $200,000 loan, a 1% origination fee would cost $2,000 in closing costs.)

So which is better — the lower rate? the higher closing costs? no closing costs at all?

In most purchase situations, it makes the most sense to pay the 1% origination fee in order to get the lowest interest rate. Here is some simple math to help show the difference between two options based on a $200,000 loan amount.

Option # 1: 1% origination fee at 6.0% interest rate.

Option # 2: 0% origination fee at 6.375% interest rate.

The difference between the two options would be $48 a month in payment and $2,000 in closing costs. $2,000 divided by $48 per month = 41.6 months, or about 3.5 years. In other words, if you are going to keep the loan for more than 3.5 years, the better decision is to pay the 1% origination fee and take advantage of the lower interest rate.

For the over-analyzing-microsoft-exel-a-nator, (made-up word) you could probably build a spreadsheet (and drive yourself moderately insane) by running out the scenario by taking what would have been the $2,000 in origination fee and calculating the “what-if” for putting that money in a 4.0% money market account for 3.5 years (where the gain would be taxable); and then add in the fact that at the higher interest rate, you are going to pay a slight bit more tax-deductible interest, where the $48 per month difference really works out to be closer to a net of $38 per month difference . . . and the $2,000 in closing costs would have grown to $2,290 (or so) over 3.5 years, but after taxes would be more like $2,240. And NOW (whew), do the math . . . $2,240 divided by $38 per month = 59 months . . . or just shy of 5 years. And, like I mentioned before, in a purchase transaction, this would make sense (the average time for a person to live in a home is around 6 to 7 years).

The same type of math works with a “no-cost” option — where the interest rate is moved up in order lender-pay all of the closing costs. This type of set-up (higher rate, no closing costs) usually works best on a refinance for people who are looking for a fixed-rate mortgage and who are only planning on being in the house for another 2 to 3 years.

So, before you jump at the idea and accept a 0% or 0.5% origination fee, make sure you are doing a fair comparison of closing costs, points and interest rate. The “deal” of a 0.5% origination — combined with a higher than market interest rate for the life of the loan — could be no deal at all.

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2 Responses to “0% origination fee — deal? or no deal?”

  1. Tina Shnell Says:

    Thank you for that article on how to comparison shop for a mortgage. It is very difficult to get a straight answer out of some of these mortgage sales people that are just trying to sell you a loan and not telling you all of this. I appreciate that you are straight forward.

    Thanks again!
    Tina

  2. Could you please just “show me the money?” « The Mortgage Blog Says:

    […] problem # 2 — different loan amounts means different closing costs.  Some of the closing costs are a percentage of the loan amount (the origination fee, any discount points, the title insurance and, for consumer borrowing in Georgia, the Georgia intangible tax are all a percentage of the amount financed).  When comparing good faith estimates, make sure the estimates are for the same loan amount. […]

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