Most of us have strolled along the boardwalk or the streets of New York and watched a street magician perform. One of the magicians favorites is to have a passerby place a ball under a cup and watch the magician begin swirling the cups, faster and faster, while I try to remember which cup has my ball. I can easily admit being burned by this trick many a time. What happens is really a simple trick of distraction. Too many cups, too few eyes. It is the same sort of trick that lenders use on their patrons, or as we affectionately call them, FOOLS.
Unlike a magician, I am not bound by any secret society promises. I can reveal these secrets without too much fear of retribution. I will take the fun out of the trick, and in the process, save you thousands of dollars in unnecessary fees.
The Shell Game
Here is how the banks play the game. First of all, they need a bunch of objects to confuse you with. For this they bring in the shells- origination fees (points), closing costs, and the interest rate (note rate). They know that in the hands of a magician, they can spin these shells and come out with the best deal for them.
IF the borrower chooses the lowest rate, the bank will jack up the point and fees. If a borrower wants the lowest fees, the bank will jack up the rate. If the borrower doesn’t want to pay any origination points, Fees and rate will go up. Anyhow, you get the jest of it…the lender will use the shells to give you what you think you want, while actually getting what THEY want.
As a borrower, you need to take the shells away, one by one. First of all, never entertain any offers that have origination points. By doing this, you have eliminated one of the lenders shells. You are now down to closing costs and the note rate. For reasons contained in my previous blog, I would eliminate the closing costs as well. By eliminating this shell, you have shifted the pressure on the bank. There is no place for them to hide, your question is simple – now that I have decided not to pay ANY closing costs, what is your best rate? Where can the bank hide? They can’t raise the processing fee, because you aren’t paying it. They can’t charge a point, because you aren’t paying it. All they have left is one shell, lift it up, and there’s the prize. A simple low rate. Lock it. You will win every time.
-Mortgage Maniac
Everyday, I sit in my office and have to watch the new ad campaign that Ditech is running and I wonder… why do they advertise the absolute worse loan that a borrower could take? Do people respond? And it makes me wonder, does Ditech really think “People Are Smart” or are they laughing behind our collective backs and the ad is really meant to be sarcastic.
Here are the details of the loan they offer:
30-Year Fixed Rate at 6.125%, but the costs, turn out to be $12,000. (Example uses $300,000 loan)
No loan professional would EVER take this loan. Here’s why:
In the first year, you have to pay the 6.125% ($18,375) PLUS the $12,000 in costs PLUS unless you wrote a $12,000 check at closing, you owe an additional $735 in interest JUST TO PAY FOR THE CLOSING COSTS. This gives you an APR of nearly 11%. At the end of the 1st year, you will still owe $309,000.
In the second year, you get to average out your costs over 2 years, so your APR drops to 8.5%. The 3rd year 7.60%, the 4th year 7.2%, etc. YOU WILL NEVER SEE THE 6.125% NOTE RATE EVEN IF YOU PAY ON THE LOAN FOR 30 YEARS.
Now, here is the KICKER. You borrowed $312,000 when you only needed to borrow $300,000. It will take you 4 YEARS JUST TO PAY OFF THE $12,000 IN COSTS. YOU WON’T BE PAYING DOWN THE $300,000 UNTIL THE 4TH YEAR INTO THE LOAN. What a great business plan…lend somebody money, and for 4 years, you collect $72,000 in payments AND THE BORROWER HASN’T EVEN BEGUN TO PAY DOWN THE HOUSE. THEY ARE MERELY PAYING YOU BACK FOR THE FEES YOU CHARGED THEM.
EPIPHANY: You can get the same loan, $300,000 ON A NO-COST BASIS for 6.625%. With the lender paying ALL the fees, your 1st payment will go towards paying off your house. By the way, the difference in payment between 6.125% and 6.625% (what did you get for your $12,000) is only *$25/month! Oh, and after 4 years, you will owe $285,000 instead of $300,000. If you decide to move, that’s an extra $15,000 in your pocket.
Don’t let the banks tell you “You are Smart” protect yourself; educate yourself, and Get Smart.
*$300,000 at 6.625% $1,920 (Principle & Interest) Vs. $312,000 at 6.125% $1,895 (Principle & Interest)
A.P.R. is a prime example of the government trying to give poorly informed consumers just enough information to make a big mistake. And like all financial mistakes, there is a benefactor –
With respect to interest rates, we are programmed to believe that the lowest interest rate (APR) is the best interest rate. The problem with this calculation is that APR is calculated OVER THE LIFE of the loan. So, for a mortgage, that typically means 30 years. So, what APR is telling us is that over the course of a loan, our rate will be X.XX%. The problem occurs when and if we don’t stay in the home, or the loan for that matter, for the full thirty years.
This is where financial analysts look at "the load" or "fees" associated with the product. Mortgages are typically front-loaded. The fees charged by the lender are paid up front. So, if for any reason, you do not stay in the home for 30 years, guess who wins? A better calculation, one which I advise ALL my clients to look at is: Effective Rate of Interest. This calculation looks at the period at which I will be in the home, and the total amount paid. The total amount paid includes all fees and interest expenses.
Let’s look at a real life example of how this works. Lets say you borrowed $200,000 on a 30-year fixed mortgage and the lender gave you two options. The 1st was a no-cost loan with a rate of 6%, the 2nd was a loan with a 5% note rate, but it would cost you $10,000 to get that rate. The 2nd rate is a bank's dream – 5% Fixed, what a GREAT Rate (for them). Here is the problem, the APR on the 1st loan would be 6% and the APR on the 2nd would be 5.2%. Simple math tells us that the 2nd loan is better. The problem begins when you consider how long you will be in the property. If you think you will be in the property for 30 years, and rates never get any better than the 5%, the 2nd option's the winner. Unfortunately, in today's fast-paced world, most Americans only live in their houses for 7 years or less. Under that situation, the 1st mortgage makes much more sense. If you are still having problems visualizing the difference, imagine if you only lived in the house for 1 year. You would have paid $10,000 in fees AND $10,000 in interest expense. With respect to the 6% loan, you only paid $12,000 for that loan. If you think this example is far fetched, it isn’t. Banks live for this stuff. We see people every day that paid $6,000+ for a loan and get transferred within a year or two. Play it safe, don’t pay any costs when you apply for a mortgage. If you do pay costs on a loan, it will take you at least 5 years to get the money back. What a great investment, in 5 years you may get a return of capital. By the way, in today's market, several lenders have no-cost rates available at the same "cost rate" as the banks. Bottom line, if a borrower thinks that they will be in the house 8 years or less, then the no-cost is the only loan that makes sense.
If you do pay costs on a loan, it will take you at least 5 years to get the money back. What a great investment, in 5 years you may get a return of capital. By the way, in today's market, several lenders have no-cost rates available at the same "cost rate" as the banks. Bottom line, if a borrower thinks that they will be in the house 8 years or less, then the no-cost is the only loan that makes sense.
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