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Mortgage: An Overview (Part 1 of 5)

Mortgages - An Overview (1): Closing Costs and Interest Rates

by Joseph Hughes

Consumers getting home loans for the first time always have questions about the process, the procedure, and the costs. This article outlines some of the steps involved in getting a mortgage. The closing costs, whether the loan is for a purchase or a refinance, are a good place to start.

A borrower wants to know the costs associated with getting a mortgage. Federal law requires that a borrower have mailed to him an estimate of the loan closing costs within three days of the lender or broker receiving a loan application. This estimate includes escrow fees, costs charged by the broker and the lender, the appraisal cost, credit report fee, title insurance, notary fees, and recording fees.

The cost of insurance does not need to be included, since this cost insurance is not considered a cost of getting the loan. The borrower, who is the owner, may choose either comprehensive coverage with a low deductible and total coverage of contents or the minimal coverage required by the lender with no coverage of the contents, in an attempt to keep premiums low. Most owners choose a middle ground. Because the type of insurance coverage is the owner’s decision and has no effect on the loan, the lender has no obligation to include the insurance costs in the cost of the loan.

Similarly, real estate taxes need not be disclosed because they are not costs directly associated with acquiring the loan. The taxes must be brought current for a refinance and pro-rated between the buyer and the seller on a purchase. The real estate taxes exist regardless of the amount or type of loan.

All lenders require title insurance on the loan to protect the lender from defects in the title of the property. The buyer will also purchase his own title insurance to protect him from title defects. This situation means two separate policies are needed, one for the lender and one for the owner of the property. If the loan is a refinance, only the lender’s policy is needed because the owner had an owner’s policy in effect from when the property was purchased. So whenever a defect in title to the property is discovered, the owner is protected by title insurance policy.

Because only the lender’s policy is required when the loan is a refinance, the closing costs are less for a refinance than for a purchase.

California also requires the broker to disclose the amount he is receiving from the lender. This payment is either a rebate or a yield spread premium; the two terms mean the same thing.

A rebate allows the borrower to get a no point or no fee loan but at a slightly higher interest rate. If the borrower pays one point, which is equal to one percent of the loan amount, he will get a slightly lower interest rate. One point, or one per cent, for a $200,000 loan equals $2000.. Each point will lower the interest rate by about a quarter of a percent so a borrower who pays two points will get an even lower interest rate. This figure is for a 30 year fixed loan and is based on a formula that makes assumptions about how long the loan will be in existence. Generally, the mathematical model assumes a loan will be extant about seven years. That assumption provides the basis for how much the different interest rates will cost. Death, divorce, hard financial times, transfer, winning the lottery, desire to down-size, and/or health issues are among reasons that people do not stay in the same home for the full 30 year term of the loan. All of these factors come into play in the formula..

Since there is a choice of interest rates with different costs, the question of what is the best interest rate is a frequent and natural one. It makes sense to consider how long a person really thinks he will be in the house, along with any other options and obligations. That provides an idea of whether it would be worthwhile for to spend the money for a lower rate and a lower monthly payment for the life of the loan. The alternative is a slightly higher interest rate and monthly payment, saving one point (one per cent of the loan amount) on the closing costs. The break-even point is about five years. The higher monthly payment is tax deductible. The loan fee may or may not be tax deductible (check with your accountant). The tax advantage adds just one more factor to consider in deciding the best interest rate. Often the decision is based on what the borrower feels most comfortable doing.

Continue to the next article in the Mortgage: An Overview series