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What Does That Loan Really Cost?

Reviewed Sep 10, 2012

Summary

There’s a lot more to a loan, be it for a home, a car or home improvement, beyond basics such as the interest rate.

You’ve found just the house you want, and you’ve found a loan that looks right. But do you really know what you’re getting into? Probably not unless you know something about loan terms and costs. There’s a lot more to a loan, be it for a home, a car or home improvement, beyond basics such as the interest rate. And interest itself can get rather complicated, as well as costly for the unwary.
 
Here’s a look at loan features that can make a difference to your pocketbook:
 
Points. “Points,” a feature of home loans, are interest paid up front. One point is 1 percent of the loan principal. The benefit of points to the borrower is twofold. First, you get a reduction in your interest rate going forward, which becomes more valuable the longer you stay in the home. Second, you can deduct points from your taxes in the year you pay them, as long as you pay them as part of your cash down payment. Chris Reuschle, a financial advisor with American Express in Jacksonville, FL, says points and interest tend to balance out, so that in a competitive loan market the lending costs are similar once you factor out the points. “If you were to compare the same loan values with zero-points interest,” he says, “the rates would be the same.”
 
Fees. These are also tacked on to the up-front costs, but they don’t necessarily pay off for the borrower. The biggest are usually the “origination fees,” typically paid to mortgage brokers. Ivy Hecker, a Bethesda, Md., financial planner with a background in real estate, notes that these are not tax-deductible as points are. They do get added to the cost basis of the home and so reduce future capital gains, but current law shields most homeowners from having to pay capital gains on their primary residence. Still, Hecker says, the origination fee may be worth paying if they get you a good overall package. “You can avoid paying it, but it may not be so bad,” she says.
 
Smaller “junk fees,” as financial advisors call them, are less defensible. These are charges for things like document delivery (when you’ve picked up the papers yourself) or notary services when a lender or broker has a full-time notary public on staff. A lender or broker who values your business should be willing to waive these.
 
Annual percentage rate. This, the ubiquitous “APR,” is one way to measure the cost of all those points and fees. It includes these with your monthly payments to calculate an interest rate that reflects what you actually pay in a given year. The higher the fees and points, the more the APR will exceed the nominal loan rate.

ARM (adjustable-rate mortgage) formulas. Borrowers have a wide range of loan choices these days beyond the traditional 30-year fixed-rate mortgage. The question of which to choose—fixed-rate or adjustable-rate—is complex, but you should know how ARMs work if you’re considering them at all. Their potential costs are not always as obvious as those of fixed-rate loans.
 
All ARMs share some basic features. They use an index, such as Treasury bill rates or a “cost of funds” indicator of what lenders are currently paying depositors in interest. This is adjusted periodically—every year or 6 months, usually. A margin, such as 2.5 percent, is added to the index to determine the rate that the borrower pays. The margin never changes.
 
The index can change a lot, but you get some protection from extreme swings through another ARM feature, the rate cap. These are of two types. One is an absolute upper limit for the interest rate. No matter how high the index goes, you’ll never pay more than this cap. Another is a limit on how much the loan can change in each readjustment.
 
Most ARMs have a 30-year term, with a low fixed rate for the first 3, 5, 7 or 10 years. After that, the index and margin are used to set the rate on the remaining principal. Those short-term rates can be tempting because they are always lower than the rate for a 30-year fixed-rate loan. But if you plan to stay in your home past the date when the loan adjusts, remember that interest rates and the related index might be a lot higher than they are now. If you want to avoid the risk of a steep hike in your monthly payments, stick with a fixed-rate loan. And, if you want fixed rates at lower interest (along with faster payment of principal), check to see if a 15-year or even 10-year fixed-rate loan is feasible for you.
 
Prepayment rules. It used to be a common practice for mortgage lenders to penalize borrowers who paid off the principal ahead of schedule. These prepayment penalties are much rarer in the home-loan market now, and you should avoid them. But with other debt, such as auto loans, you can still face prepayment rules that lead to higher costs than you might expect. In all amortized loans—those paid off in equal installments—you pay most of the interest early and most of the principal late. Under the “Rule of 78s,” used by many lenders to set prepayment amounts, you may find you owe a surprisingly large chunk of principal well into the loan period. See the list of “On the Web” resources below for a site that can help you understand this rule and figure out how it may affect you.
 
Resources
 
Books:
 
Among the many books on borrowing, one especially focused on home loans is Mortgages for Dummies, 3rd ed., by Eric Tyson and Ray Brown (Wiley, 2008);  Mortgages are also covered in Tyson and Browns’s Home Buying for Dummies, 4th ed., (Wiley, 2009).

On the Web:

The Mortgage Bankers Association, the trade group of the home-loan industry, has a wide-ranging consumer site at http://www.homeloanlearningcenter.com/default.htm.

The Illinois state Division of Banks and Real Estate has a good consumer site that explains the Rule of 78s, among much else. Go to www.obre.state.il.us/CONSUMER/Tips/CONTIPS.HTM and see the list of links under “Consumer Tips.”

To see the amortization schedule for a loan, showing just how much of your interest and principal will be paid at each installment, go to the mortgage calculator page at Bankrate.com: http://www.bankrate.com/calculators/mortgages/mortgage-calculator.aspx

By Tom Gray
Source: Mortgage Bankers Association; Chris Reuschle, financial advisor, American Express Financial Advisors, Jacksonville, FL; Ivy Hecker, certified financial planner, NexTier Financial Advisors Inc., Bethesda, MD

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