Rate, Points and Fees: a Mortgage Buyer’s Guide

Periodically, I hear the same question from enough people that I know it’s time for a detailed primer on some part of the mortgage process. So today, let’s take a close look at how mortgage interest rates and fees are determined, what “points” are, and what you need to know to make sure you’re getting the best possible deal on your loan.

First, a definition: a “point” is 1% of the loan amount, also rendered as 100 basis points, or bps.

Before we talk about “paying points”, we ought to divide the costs of the loan from the costs of the rate for the loan. There are two sets of costs, and they don’t really have very much to do with each other. This is, I think, a major point of confusion.

Cost of the loan: To borrow $200,000 costs X. X varies a bit from lender to lender, just like the cost of grapes from grocery store to grocery store. Do not be confused here by “no-cost refinances”; the cost is still there, however you hide it, just as grapes cost money even if someone happens to be giving them away.

Cost of the rate: Different rates cost different amounts, just as faster cars cost more than slower ones.

Keep those two principles in mind as we go through an example.

Jane wants to get a $200,000 loan. This is going to cost Jane $4000. Now Jane has to decide what rate she wants on the money. People call up all the time and say “what are rates today”, which is exactly like calling a car dealership and asking “how fast are your cars?” Which car? What engine? How fast do you want them to be?

Lenders sell their money to brokers, and the price sheet for that money is called a rate sheet. On that sheet is the cost of any rate Jane could want. At lower rates, the lender will charge the broker, and at higher rates the lender will pay the broker. Want an example? Here you go:

The rate where the broker makes nothing from the lender and pays nothing   to the lender is called par. The closest to par on this sheet is 4.75%, in red there. As you see, the broker is actually making a couple bucks at that rate – .162 x the loan amount, to be exact. Usually, a broker will quote you a rate higher than par, so he can make some money on the margin.

This may look complicated, but it isn’t. Think of it like a car dealership. There’s the base cost, and then the sales price, which is the base plus the dealer markup. As you would expect, the better car you get, the more it costs. And just like at a dealership, a lender can sell you a crappy car for the same price as a good one, and pocket the difference. This is why, unless you have a dealer you trust, you always compare prices, and the same should absolutely hold true for mortgage brokers.

So in our example, the wholesale rate is 4.75%. The lender quotes Jane 5% as the rate for her loan. If Jane wants a better rate, say, 4.5%, it will cost .248 (times the loan amount) – this is called paying points. If she wants 5.5%, Jane should get back a chunk of money to defray her loan costs.

In other words, JANE should decide what her rate is, not her broker. The lower she wants it, the more it will cost. The higher she can stand it, the less it will cost, to the point that at some rates, the rate will pay her, and eliminate some of the cost of the loan.

Thus:

And that’s how it works. It works this way for every lender, no matter what they tell you.

Now that you know the super double-secret mortgage code, here’s the fastest way to use this knowledge to get a good deal: get three Good Faith Estimates (GFEs), one for each rate you pick. The difference in closing costs will tell you how much of the fees are loan fees and how much are rate fees. Then you can decide whether you want a great rate and more fees, or great fees and a higher rate.

See? It’s not rocket science. But I guess I wouldn’t call it simple, either.

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