Have you ever been perplexed or troubled after finding out that a neighbor or coworker has a substantially lower mortgage rate than you do, even if you bought the properties at about the same time? You're not alone, but we'll let you in on a little secret - there is no free lunch in finance. So, while your neighbor or co-worker may genuinely believe he or she got a terrific deal, this may not be the case.

The mortgage market is extremely competitive, and in the origination process, there's usually a tradeoff between loan closing costs and interest rates. Unless you neglected to shop around and truly paid too much, your neighbor or co-worker with the lower interest rate may have paid much higher closing costs than you did. Furthermore, those closing costs were probably rolled into the loan balance, making it appear that the borrower received something for nothing.

So how can you ensure that you really get a good deal? We'll show you how to shop for and compare mortgages based on their real costs.

Collecting Quotes
A mortgage might be the single largest financial decision you ever make, so do some homework and shop around. Collecting at least three quotes from different lenders should help ensure that you find a good deal. While shopping, be aware of the tradeoff between mortgage costs, including discount points, and the interest rate on the mortgage. A lender that offers very low-cost or no-cost mortgages has to make money some way, and that is usually accomplished by charging a higher interest rate.

Most newly originated mortgages are sold immediately into the secondary markets. Generally speaking, the higher the interest rate on the mortgage, the higher the rate will be on the secondary market product. A lender who offers low costs and fees can recoup his or her own costs in the secondary market by charging a higher interest rate. A lender who has higher costs may not have to charge as high of an interest rate to make the same amount of profit. (For more on the secondary mortgage market, see Behind The Scenes Of Your Mortgage.)

Comparing Costs
There are many costs associated with a mortgage. They vary by name and amount, from lender to lender and from state to state. Without a doubt, it is confusing, and that's sometimes the way lenders intend it to be - it makes it harder for you to shop around.

One strategy for sorting through mortgage costs, whether dealing directly with a lender or with a mortgage broker, is to ask for a list and a guarantee of total mortgage settlement costs. This should be done in the shopping stage, before an application is taken, and before a "good faith estimate" (as is required by law) is provided. The lender or broker should be willing and able to provide the list, but will most likely not be able to guarantee all of the fees because some fees, such as title insurance, are charged by third parties. The key is to identify the fees that are charged directly by the lender and can be guaranteed, as well as the third-party fees, which cannot be guaranteed. Compare both types of fees from lender to lender. Try to identify whether a lender might be low-balling or excluding third-party fees to make a deal look more attractive. (For more on this topic, read Shopping For A Mortgage.)

Comparing Interest Rates
The quotes on the costs that you collect from each lender should be tied to a specific interest rate for a specific loan amount, and should include any discount points. It's possible that the interest rate could change as overall market conditions change from the time the quote is provided to the time you're ready to lock it in, but the idea is to try and make an apples-to-apples comparison on interest rates versus costs. You should collect all of your quotes within a short time frame and try to ensure that there hasn't been any significant rate movement between quotes. (For related reading, check out Got A Good Mortgage Rate? Lock It Up! and How Will Your Mortgage Rate?)

Discount Points
Discount points, typically known simply as "points", are prepaid or capitalized interest on a mortgage. They are expressed as a percentage of the loan amount. For example, one point might equal 1% of the loan amount. Paying points lowers the interest rate on the mortgage. Because points are prepaid interest, they generally have the benefit of being tax deductible. Discount points should be part of your analysis on the costs side. Incorporating the tax savings associated with discount points into an analysis of mortgage options is also a viable option. (To learn more, read Mortgage Points - What's The Point? and A Tax Primer For Homeowners.)

The Mortgage Balance
Too often, borrowers make the mistake of not accounting for costs when those costs are rolled into the loan balance. For example, a no-cost mortgage is much different than a no-cash mortgage. A no-cost mortgage might truly have no costs (although it will likely have a higher interest rate), while a no-cash mortgage will have costs, but those costs are not paid out of pocket; they are rolled into the mortgage amount. While rolling mortgage costs into the loan balance might raise the monthly payment only slightly when amortized over 30 years, it can significantly add to the amount of total interest that is paid over those 30 years, and reduce your net worth by reducing the amount of initial equity you have in your home.

Making a Comparison of Mortgages
Comparing the quotes you've collected is a five-step process.

  1. Start by finding a good online mortgage calculator, which will allow you to calculate monthly payments and remaining principal balances by month.
  2. Calculate the difference in monthly payments between your mortgage quotes for each month for about the first 10 years of each mortgage. This can be easily done by copying and pasting values from the online calculator into a spreadsheet. Subtract the lower monthly payments from the highest monthly payment for each month. It's important to remember that if you roll the costs of the mortgage into the original balance you should base your calculations on that total loan amount.
  3. Calculate a cumulative sum (running total by month) of the monthly payment savings each loan has over the mortgage with the highest monthly payments. If you're paying closing costs out of pocket, subtract the difference in costs (cost savings of one loan over another) from your cumulative monthly payment savings. (This is to be done only once, as part of the cumulative totals.)
  4. Subtract the amount calculated in Step 3 above from the remaining principal balance of each mortgage for each month.
  5. Identify your time horizon - the estimated amount of time you expect to live in the house or otherwise have the mortgage. At the end of your time horizon, the mortgage with the lowest value as calculated in Step 4 above is the most economical mortgage choice. The most economical choice by month is highlighted in blue in the example below.

Note: If you plan on rolling your mortgage costs into the initial principal balance of the mortgage, then there is no need to make the difference in costs calculation in Step 3. The difference in costs between the different quotes will be accounted for in the monthly payment differences and remaining principal balance differences, which are tied together in Step 4.

$300,000 30-Year, Fixed Rate Mortgage Quote Comparison
Quotes Interest Rate Closing Costs Including Points Difference in Costs
Quote 1 7% $9,200 $6,300
Quote 2 7.125% $5,850 $2,950
Quote 3 7.25% $2,900 $0

Comparison of Costs: Months 1-5
Monthly Payments Monthly Payment Differences Cumulative Monthly Payment Differences Total Savings (Including Closing Cost Differences)
Month Quote 1 Quote 2 Quote 3 Quote 1 Quote 2 Quote 3 Quote 1 Quote 2 Quote 3 Quote 1 Quote 2 Quote 3
1 $1,996 $2,021 $2,047 $51 $26 $0 $51 $26 $0 ($6,249) ($2,924) $0
2 $1,996 $2,021 $2,047 $51 $26 $0 $102 $52 $0 ($6,198) ($2,898) $0
3 $1,996 $2,021 $2,047 $51 $26 $0 $153 $78 $0 ($6,147) ($2,872) $0
4 $1,996 $2,021 $2,047 $51 $26 $0 $204 $104 $0 ($6,096) ($2,846) $0
5 $1,996 $2,021 $2,047 $51 $26 $0 $255 $130 $0 ($6,045) ($2,820) $0
Comparison of Costs: Months 116-120
116 $1,996 $2,021 $2,047 $51 $26 $0 $5,916 $3,016 $0 ($384) $66 $0
117 $1,996 $2,021 $2,047 $51 $26 $0 $5,967 $3,042 $0 ($333) $92 $0
118 $1,996 $2,021 $2,047 $51 $26 $0 $6,018 $3,068 $0 ($282) $118 $0
119 $1,996 $2,021 $2,047 $51 $26 $0 $6,069 $3,094 $0 ($231) $144 $0
120 $1,996 $2,021 $2,047 $51 $26 $0 $6,120 $3,120 $0 ($180) $170 $0

Quote 3 Shows Lowest Costs in Months 1-5
Remaining Principal Balances Principal Balance - Cumulative Savings
Month Quote 1 Quote 2 Quote 3 Quote 1 Quote 2 Quote 3
1 $299,754 $299,760 $299,766 $306,003 $302,684 $299,766
2 $299,507 $299,519 $299,531 $305,705 $302,417 $299,531
3 $299,258 $299,276 $299,294 $305,405 $302,148 $299,294
4 $299,008 $299,032 $299,055 $305,104 $301,878 $299,055
5 $298,756 $298,786 $298,816 $304,801 $301,606 $298,816

Quote 1 Shows Lowest Costs in Months 115-120
115 $259,865 $260,587 $261,299 $260,300 $260,547 $261,299
116 $259,385 $260,113 $260,831 $259,769 $260,047 $260,831
117 $258,902 $259,636 $260,360 $259,235 $259,544 $260,360
118 $258,417 $259,157 $259,886 $258,699 $259,039 $259,886
119 $257,928 $258,674 $259,410 $258,159 $258,530 $259,410
120 $257,437 $258,189 $258,931 $257,617 $258,019 $258,931


Explanation of Results

Traditionally, the simplest way to make a decision about whether to pay discount points is to sum the monthly payment savings realized by paying points each month until the month in which that cumulative sum equals the dollar cost of those points. If you think you'll have the mortgage for longer than the month identified, paying points generally makes sense. That same methodology can be used for refinance decisions, and comparing different interest rate and closing costs between lenders. In the example above, we've refined that methodology to recognize that the remaining principal balance of a mortgage is important - it's part of the home equity equation that figures into a household's net worth. The key fact is that the lower the interest rate on a mortgage, the faster the principal balance of that mortgage is reduced. For example, as shown above, in month 120, the remaining principal balance of the 7% mortgage is $1,494 less than that of the 7.25% mortgage. (If you're good with spreadsheets, you could refine the equation even more to include tax savings and reinvestment rates)

Conclusion
In the mortgage market, there is always a tradeoff between costs, including discount points, and interest rates. When shopping for a mortgage, collect a few different quotes that include both costs and interest rates, then spend some time running the numbers. It could save you a lot of money or add a lot of value in the long run.

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