What Is the "Price" of a Mortgage?
December 4, 2000
"I’m a first-time home buyer shopping for my first mortgage and find myself confused about what I’m shopping for. I understand interest rates (I think), but I also hear about fully-indexed interest rates, points, rebates, origination fees, junk fees, maximum interest rates, and margins. Please sort this out in a way I can understand."
I'll try.
Interest rate is the number that is multiplied by the loan balance to get the interest payment due the lender. The rate quoted on a mortgage is an annual rate, but it is applied monthly. On a 6% mortgage with a $100,000 balance, for example, the monthly interest due is .005 times $100,000, or $500.
On a fixed-rate mortgage (FRM), the interest rate is preset for the life of the loan. On an adjustable rate mortgage (ARM), the rate is preset for an initial period, ranging from 1 month to 10 years, and then can change.
Points are upfront charges expressed as a percent of the loan amount. Two points amount to 2% of the loan.
Points are related to the interest rate. If a lender offers a 30-year FRM at 8% and zero points, for example, he might charge 1.75 points for a 7.5% loan.
Rebates are points paid by (rather than to) the lender for high-rate loans. The lender who charges 1.75 points for a 7.50% loan, for example, might rebate 2 points for a 9% loan. The 2 points would be available to defray the borrower’s settlement costs.
Origination fees are points in disguise. Some lenders charge origination fees because reporting services and newspapers show rates and points but not origination fees. The lender who charges 1 point and a 1% origination fee looks cheaper than the lender who charges 2 points and no origination fee. To the borrower, points and origination fees are the same.
"Junk fees" is a nasty term sometimes used to describe all other upfront charges by the lender or mortgage broker. Junk fees are expressed in dollars rather than as a percent of the loan. On my web site I have a long list of items that some lenders may charge for, but for the borrower shopping the market, only the total matters.
In sum, the price of a mortgage has three components: interest rate, total upfront charges expressed as a percent of the loan, and total upfront charges expressed in dollars.
ARM shoppers who confidently expect to be out of the house before the end of the initial rate period need concern themselves only with the initial rate. But ARM shoppers who are uncertain about how long they will be in their house should have two indicators of what might happen to the ARM rate after the initial rate period ends.
The fully indexed rate (FIR) tells them where the ARM rate will go in a stable interest rate environment. The maximum rate tells them where the ARM rate will go in a rising rate environment.
The fully indexed rate (FIR) is the sum of the interest rate index used by the ARM and the fixed margin that is added to it. Both the index and the margin are specified in the ARM contract.
For example, many ARMs use the Treasury one-year index, which had a value on Dec. 6, 2000 of 5.72%. On that day, an ARM that uses this index and has a margin of 3% had a FIR of 8.72%. At the end of the initial rate period need concern themselves only with the initial rate. But ARM shoppers who are uncertain about how long they will be in their house should have two indicators of what might happen to the ARM rate after the initial rate period ends.
The fully indexed rate (FIR) tells them where the ARM rate will go in a stable interest rate environment. The maximum rate tells them where the ARM rate will go in a rising rate environment.
The fully indexed rate (FIR) is the sum of the interest rate index used by the ARM and the fixed margin that is added to it. Both the index and the margin are specified in the ARM contract.
For example, many ARMs use the Treasury one-year index, which had a value on Dec. 6, 2000 of 5.72%. On that day, an ARM that uses this index and has a margin of 3% had a FIR of 8.72%. At the end of the initial rate period, assuming the interest rate index does not change from its initial value, the rate on the ARM will move toward the FIR.
The maximum rate is the highest rate permitted by the ARM contract. Even if interest rates explode, the ARM rate cannot exceed this maximum.
It is also useful for an ARM shopper to know whether rate adjustments at the end of the initial rate period will be abrupt or gradual. This depends on how frequently rates are adjusted, and on the cap (if any) on how large a rate adjustment can be. Detailed examples are provided in Information Needed to Evaluate an ARM.
"I’m a first-time home buyer shopping for my first mortgage and find myself confused about what I’m shopping for. I understand interest rates (I think), but I also hear about fully-indexed interest rates, points, rebates, origination fees, junk fees, maximum interest rates, and margins. Please sort this out in a way I can understand."
I'll try.
Interest rate is the number that is multiplied by the loan balance to get the interest payment due the lender. The rate quoted on a mortgage is an annual rate, but it is applied monthly. On a 6% mortgage with a $100,000 balance, for example, the monthly interest due is .005 times $100,000, or $500.
On a fixed-rate mortgage (FRM), the interest rate is preset for the life of the loan. On an adjustable rate mortgage (ARM), the rate is preset for an initial period, ranging from 1 month to 10 years, and then can change.
Points are upfront charges expressed as a percent of the loan amount. Two points amount to 2% of the loan.
Points are related to the interest rate. If a lender offers a 30-year FRM at 8% and zero points, for example, he might charge 1.75 points for a 7.5% loan.
Rebates are points paid by (rather than to) the lender for high-rate loans. The lender who charges 1.75 points for a 7.50% loan, for example, might rebate 2 points for a 9% loan. The 2 points would be available to defray the borrower’s settlement costs.
Origination fees are points in disguise. Some lenders charge origination fees because reporting services and newspapers show rates and points but not origination fees. The lender who charges 1 point and a 1% origination fee looks cheaper than the lender who charges 2 points and no origination fee. To the borrower, points and origination fees are the same.
"Junk fees" is a nasty term sometimes used to describe all other upfront charges by the lender or mortgage broker. Junk fees are expressed in dollars rather than as a percent of the loan. On my web site I have a long list of items that some lenders may charge for, but for the borrower shopping the market, only the total matters.
In sum, the price of a mortgage has three components: interest rate, total upfront charges expressed as a percent of the loan, and total upfront charges expressed in dollars.
ARM shoppers who confidently expect to be out of the house before the end of the initial rate period need concern themselves only with the initial rate. But ARM shoppers who are uncertain about how long they will be in their house should have two indicators of what might happen to the ARM rate after the initial rate period ends.
The fully indexed rate (FIR) tells them where the ARM rate will go in a stable interest rate environment. The maximum rate tells them where the ARM rate will go in a rising rate environment.
The fully indexed rate (FIR) is the sum of the interest rate index used by the ARM and the fixed margin that is added to it. Both the index and the margin are specified in the ARM contract.
For example, many ARMs use the Treasury one-year index, which had a value on Dec. 6, 2000 of 5.72%. On that day, an ARM that uses this index and has a margin of 3% had a FIR of 8.72%. At the end of the initial rate period need concern themselves only with the initial rate. But ARM shoppers who are uncertain about how long they will be in their house should have two indicators of what might happen to the ARM rate after the initial rate period ends.
The fully indexed rate (FIR) tells them where the ARM rate will go in a stable interest rate environment. The maximum rate tells them where the ARM rate will go in a rising rate environment.
The fully indexed rate (FIR) is the sum of the interest rate index used by the ARM and the fixed margin that is added to it. Both the index and the margin are specified in the ARM contract.
For example, many ARMs use the Treasury one-year index, which had a value on Dec. 6, 2000 of 5.72%. On that day, an ARM that uses this index and has a margin of 3% had a FIR of 8.72%. At the end of the initial rate period, assuming the interest rate index does not change from its initial value, the rate on the ARM will move toward the FIR.
The maximum rate is the highest rate permitted by the ARM contract. Even if interest rates explode, the ARM rate cannot exceed this maximum.
It is also useful for an ARM shopper to know whether rate adjustments at the end of the initial rate period will be abrupt or gradual. This depends on how frequently rates are adjusted, and on the cap (if any) on how large a rate adjustment can be. Detailed examples are provided in Information Needed to Evaluate an ARM.