The Battle of the Interest Rate vs. Lower Closing Costs

By Bridgette Fanucchi Published Nov 15, 2007 03:52 pm Updated Feb 3, 2015 11:22 am

A friend of mine was buying a new home recently and was very excited about the closing costs he was receiving from the builder. With the $20,000 closing costs and about $12,000 drop in price, he was counting the dollars he would save. There was just one catch in this real estate diamond — the builder required him to use its mortgage company and settlement partner.

It looked pretty good at first — while the lender had quoted a lower interest rate than its competitors, the closing costs looked a bit high — in fact $10,000 higher than the mortgage company that was charging the higher rate. So which one do you choose?

An estimate of closing costs is not only good real estate practice; it’s also required by law. Lenders must provide a Truth in Lending Statement of what it will cost the buyer to actually borrow the money to purchase a property. Be careful on how your comparing mortgages. An origination fees and loan buy-down fee for the lower interest rate, could make the lower payment actually cost you more.

Here’s how to determine if you’re really getting a good deal. Let’s say the mortgage is for $350,000 and you’re comparing 6.0 and 6.25 interest rates. The difference is in the monthly payment and total interest paid over the term of the loan. At 6.0 percent, the borrower would pay $2,098.43 in principle/interest payments per month. Over the life of the loan, the total interest paid would be $405,431.84.

For the same loan amount at 6.25 percent, the monthly payment would be 2155.01 — that’s $425,803.72 in interest payments over 30 years. On a year to year basis, it would save the borrower roughly $57 per month — $684 per year. As you can see, over the 30 years, the lower interest rate would cost the borrower more than $20,000.

However, in most programs, to get the 0.25 percent difference, it cost a discount point — prepaid interest. In a cheaper market, this may be worth the investment. However, on more expensive mortgages it could take years to make back the money. If the borrower is like an average homeowner, he may never make back the point money if he moves within 5 to 7 years.

Thus to reduce the interest rate on the mortgage above, the borrower would have to pay $3,500 at settlement to receive the lower mortgage payment. To make back the $3,500 at a savings of $57 per month would take over 5 years. So the question is — do you want to put out the money upfront to get the lower payment or do you want to keep your money at the table and use it for something else? Most borrowers I’ve shared this with say they would rather take the higher payment and keep their cash.

Another expense to keep in mind is the origination fee — the cost some lenders charge just for doing the mortgage for you. Be sure to ask your lender up front if this is part of the closing costs and is it payable at the table or rolled into the loan amount. Be careful for shopping interest rates alone. You want to shop the WHOLE mortgage — interest rates, origination fees, discount points, and various other fees tacked on by the lenders and settlement companies. If they suggest rolling these items into the mortgage it means your house is getting more and more expensive. Remember, when purchasing a property, you’re not just buying a house, you’re also buying a mortgage.

Back to my friend. When he reviewed his estimate from the higher interest rate lender — there would have been no origination fee — which would have saved him nearly $4,000 at the table. Keep shopping interest rates, and you may find yourself with a real low one, but at a price.