Low Closing Costs vs. Higher Interest Rate
Many times a lender will advertise very low or no closing costs but is this really a good deal? The answer as with many financial questions is “it depends”. Each person’s financial situation and goals are unique but here are some guidelines to help you make the financial decision that is in your best interest.
Low closing costs usually come with a interest rate that is slightly higher than the market rate for that type of loan. The reason is the lender will have to pay the costs to originate a loan that the borrower is not paying. The lender recoups these costs by charging a slightly higher interest rate.
If a lender’s costs to originate a $100,000 loan are $1,000 and they only charge the borrower $250 but the rate they charge is .25% higher than you would pay elsewhere, the lender will recoup the $750 of costs they paid in approximately 3 years ($100,000 x .25% x 3 = $750).
On a $300,000 loan they would recoup their costs in only one year! The borrower is paying the lender back through higher interest payments. On a $100,000, 30 year loan at 3.25% vs 3.0%, the borrower will pay $4,896.82 in additional interest over 30 years and most of that is in the early years.
In fact, over the first 5 years you will have paid $1,216.53 more in interest by choosing the loan with low closing costs! The higher the loan amount the higher the amount of additional interest will be.
So why would anyone ever go for lower closing costs vs a lower rate? Let’s say you know you are planning on selling your house in a year but you want to take advantage of the low rates by refinancing now. If you loan amount in the previous example was less than $300,000, you would be better off financially to chose the loan with the lower closing costs. The lower the loan amount, the better off you would be by choosing the low closing cost option.
Conversely, let’s say you are buying or refinancing your “forever home”. You should look for the lowest rate possible, even if you have to pay points to buy down the rate. The typical payback for the extra points is between 5 to 7 years and after that you are saving money for the remainder of the loan.
Each person’s financial situation is different and the information contained in this article is for general guidance. Please consult a mortgage professional to discuss your unique situation and determine the best option for you.