One of the least understood concepts on mortgage loans is the interest rate. I know this because I field questions daily such as “what’s your interest rate?”, which indicates that borrowers do not understand that banks can give them any interest rate within a certain range. The lower the interest rate the more the borrower has to pay to capture that interest rate. The higher the interest rate the more money the bank will give the borrower to offset, and even cover, your closing costs. This article strives to educate borrowers on how pricing on interest rates work for mortgages and how to decide which one is best for you.

Interest rate pricing

Some lenders tell everyone that they have to take a specific interest rate. More beneficial to borrowers however, is the fact that most companies give borrowers a range of interest rate options. Each interest rate option comes with different pricing and borrowers can pick which one they want. To illustrate, say you wanted to do a 3% loan, then the bank may ask you to pay some money (say 1% of the loan amount). If you wanted a 3.125% interest rate, then you might not have to pay anything and the bank wouldn’t give you any money for your closing costs (called “par pricing”). If you wanted a 3.25% interest rate, then the bank may give you some money (say 1% credit) to cover your closing costs. And if your closing costs are 1% of your loan amount, then by taking the 3.25% interest rate you’d be taking an interest rate where the bank covers all of your closing costs. This is commonly called “rolling the closing costs into the interest rate”. This range of interest rate pricing applies to all types of loans including government loans such as VA, FHA, and USDA loans.

Hows do lenders make money?

Your lender doesn’t care whether you pick a 3% interest rate or a 3.25% interest rate in the example above. Remember that our loan is a stream of income to the bank receiving your monthly mortgage payments. If you have a low interest rate, then the lender makes less income over the life of the loan, and to make up for that, the bank would want you to pay money on the day the loan closes. If you have a higher interest rate, then the lender will make more income during the life of the loan, and for that higher income stream the lender is willing to give you money on the day the loan closes. Since most loans are sold in the secondary market shortly after your loan file closes, most lenders set their pricing in lock step to what investors in the secondary market are offering for loans at each interest rate.

How to compare pricing between lenders

Say bank A is offering you a 3.25% interest rate and bank B is also offering you a 3.25% interest rate. How to do you pick which bank to go with? Well, say bank A is offering you that 3.25% interest rate and willing to give you 1% of your loan amount as a credit to offset your closing costs, while bank B is willing to give you only .75% of your loan amount to offset your closing costs. In this case you should pick bank A because they are willing to give you a larger credit, all else being equal. This is where the term mortgage rate pricing earns it’s name. The “price” is better with bank A.

There are some important points to make. Some banks show better pricing, but charge higher junk fees (such as “administration fees”, “underwriting fees”, or “processing fees”) that can make their overall pricing worse after accounting for all of the different fees. Also, don’t be fooled by banks advertising things like “free appraisals” or “we’ll waive our fees”, as they probably make up for it by having worse interest rate pricing. You always need to look at the net pricing or APR after factoring in all of the lender fees.

Picking your interest rate

What’s important to consider is your time horizon. To illustrate, you’d save $34.15 a month by taking a 3.125% interest rate versus taking a 3.25% interest rate on a $500,000 loan. However, in the example above by taking the 3.125% option you forgo a 1% credit that the bank would have given you if you took the 3.25% option; the 1% credit equates to $5,000 on a $500,000 loan. The monthly payment on a 3.125% versus 3.25% is $34.15 less. If you chose the 3.125% interest rate, it would take you 146 months to “recoup” the $5,000 credit you opted not to take, which equates to 12.2 years. After 12.2 years, then you’d truly start saving the $34.15 per month. So if you are very sure that you’ll live in your house and don’t refinance for 12.2 years or more, then it makes sense to take the lower interest rate and forgo the $5000 credit. However, if you are not extremely sure, then you’re better off taking the higher interest rate and taking the $5000 credit so you don’t have to pay your own closing costs out of pocket.

You will also need to consider how much money you have in the bank. Say you have some money in the bank, but want to keep it there instead of spending it on your closing costs. If keeping the money you have in the bank what’s important at the time of getting your mortgage loan, then take the slightly higher interest rate and let the lender pay your closing costs. You’re monthly payment will be a little more per month, but keeping a chunk of money in the bank might be more important to you at that time.

So when you ask banks to quote interest rates, you should always ask them what the price of that interest rate is. You can also ask them what the price is for a lower interest rate, and what the price is for a higher interest rate. If you already know that you want a credit to offset your closing costs, then you can straight away, “what interest rate can you offer that comes with X amount of credit?” (X being the amount of your estimated closing costs). And make sure that you consider the lender’s fees to confirm that they don’t over charge on the fees just so that they can advertise good interest rate pricing.

*All examples of interest rates and pricing are shown for illustration purposes only. Actual pricing  changes daily and depend on individual characteristics of each borrower.

Some wealthy individuals are fortunate enough to be in the position of being able to fund a home purchase without taking out a mortgage. However, paying for a home with cash instead of taking out a mortgage can be poor investment execution in a great asset for at least three good reasons.

First, the U.S. federal tax code makes mortgage financing exceptionally cheaper than the interest rate shown on your mortgage statement. As a result, you can almost always find better ways to use your cash than using it to avoid a mortgage. Second, while on the surface paying all cash for a house seems like a conservative option, in reality it can be a risky strategy, as it may be difficult to access your money quickly should a financial disaster create the need. Finally, by limiting your home purchase to the amount of cash you have to invest in your home, you assume all the risks of equity ownership without the benefit of leverage, which allows you to gain a more significant return on equity on terms of your home’s appreciation.

How to profit from your cash

The most important argument in favor of mortgage financing is the mortgage interest tax deduction allowable on both federal and Hawaii state tax codes. The principle benefit to the taxpayer is that the interest from mortgages on your primary residence (and second home, if applicable) has an aggregate deduction limit for mortgages up to $1,000,000, or a combination of $1,000,000 in mortgages and $100,000 in home equity loans, for a total of up to $1.1 million.

For individuals in the highest federal tax bracket of 39.6%, who would also be in the 11% Hawaii state tax bracket, a mortgage interest rate of 3.5% pre-tax equates to an effective 1.88% mortgage interest rate after factoring in the mortgage interest deduction. This calculation is done by taking Hawaii’s top income tax rate of 11% and adding this to the federal rate (and backing out 39.6% of 11% because state taxes are deductible on a federal return) giving a marginal tax rate of 46.2%.

Put another way, at the top tax brackets every penny invested in a house in excess of the down payment necessary to obtain a mortgage earns 1.88% after tax in Hawaii. A more profitable alternative would be to purchase something like high quality, tax-exempt municipal bonds, which currently yield about 3.00% (also on an after-tax basis).

To quantify this, suppose you are a high-earning Hawaii resident, have $1.25 million in cash and are buying a house worth $1.25 million. Strategy A is to pay for the home in all cash. Strategy B is to put $250,000 down, take out a $1 million mortgage to finance the home purchase, and invest the remaining $1 million in municipal bonds. At the end of a year, Strategy B would cost $31,828 in gross mortgage interest, generate $15,411 in income tax savings and yield $30,000 in tax-exempt interest income for a profit of $13,583 in the first year. This example looks at just municipal bonds as the only alternative investment for simplicity’s sake only. A diversified portfolio consisting of multiple asset classes is better on a risk-adjusted basis than a 100% investment in any one asset class.

Liquidity and Risk

Real estate is not liquid. We never know if we’ll be able to sell the home quickly at an advantageous price at any given time, for example, during a recession. Also, if you lose your job or suffer a business setback are the times when you may need to access the equity tied in your home, but they are also the times when banks are least willing to lend. Liquid financial assets, on the other hand, can more easily be tapped as needed.

The mortgage interest deduction is not a secret, but the idea that mortgage financing is a more profitable option even with a conservative portfolio can surprise many. It must be mentioned that the value of your investments will rise and fall. Therefore in these situations I recommend a conservative diversified portfolio with a long term time horizon focusing on yield to minimize value fluctuations even for those with a high risk tolerance.

The go to fixed rate mortgage term for most borrowers is 30 years, but would you be better off with a 15 year fixed rate mortgage instead? This article explains what factors to consider when deciding between a 15 year mortgage and a 30 year mortgage.

The loans are similar in structure – the main difference is the length of the mortgage term. A shorter term means higher monthly payments, which seem less affordable, however by shortening the term it actually makes the loan cheaper, as you end up paying much less interest over the full life of the loan.

Example on a $500,000 mortgage

15 year fixed rate mortgages are roughly 3% today

Monthly payment: $3,452

Total interest paid to the bank: $121,523

30 year fixed rate mortgages are at roughly 3.75% today.

Monthly payment: $2,315

Total interest paid to the bank: $333,608

Can you afford the higher monthly payment that comes with a 15 year mortgage?

Interest rates on a 15 year mortgage will always be lower than interest rates on a 30 year mortgage, however even after accounting for the lower interest rate, since you are paying your loan off in half the time, you’re monthly payments will be higher. But since you’re paying your principle balance off faster, you’ll save money by paying less interest to the bank over the life of the loan (about 64% less interest in the example above).

Generally, my advice is that if you can afford the higher payments associated with the shorter 15 year mortgage, you have job & income security, at least 6 months of living expenses saved in the bank for emergencies, you pay your credit card bills in full every month, you can still set aside money for retirement, your kid’s college, and other important things in your life, then you should go with a 15 year term. However, if a 15 year mortgage payment means that you have to carry credit card debt monthly, you cannot save money, or invest in anything else important to you, then it’s not advisable.

Are you looking to refinance?

If your current payments on a 30 year mortgage are at a much higher interest rate and your current mortgage balance has been paid down low enough, you might be able to refinance into a 15 year mortgage with monthly payments close to what you were paying, while shortening your mortgage term.

One of the most attractive aspects of a 15 year mortgage is the current difference, or spread, between interest rates on 15 year and 30 year mortgages. Currently, the difference in interest rate between a 30 year fixed rate mortgage and a 15 year fixed rate mortgage is about .75%, and it has ranged historically anywhere between .25% to 1%. In addition, there can price adjustments on 30 year mortgages that don’t exist on 15 year mortgages, which make 30 year mortgages more expensive for borrowers.

How far away from retiring are you?

It’s important to considering how old you are and when you plan on retiring when determining if a 15 year fixed rate mortgage is right for you. If you are in the 20’s to 30’s age range, then it might be best to put your extra money that would go toward paying a 15 year mortgage toward retirement instead. That’s because by saving for retirement early, you let the magic of compounding interest and reinvested dividends grow substantially over a longer period of time.

However, if you are 40 years old or more, then leaning toward a 15 year mortgage may make more sense as you can plan to have your house paid off about the same time you plan to retire; relieving yourself of a mortgage payment during your retirement years. That being said, you still have to weight paying more money toward mortgage debt against the need of saving for retirement, so hopefully you’ve saved a significant amount in your early years, or are making enough money to adequately save for retirement and pay down your mortgage at the same time.

Are you a good saver?

Some people just aren’t good at saving money, and for those people a 15 year mortgage may be a better choice because it forces them to save by way of building equity faster, so the house, which normally appreciates in value, acts a make-shift savings account. Those who choose a 15 year mortgage also save more because they pay less, about 64% less in the example above, in mortgage interest to the bank over the life of the loan.

Best of both worlds

If you cannot afford the higher payment that comes with the 15 year fixed mortgage, then the option that gives you some of the benefit is to take a 30 year fixed mortgage and simply make larger monthly payments as if you took out a 15 year mortgage. If you make the extra principle payments, then you’ll still pay off the mortgage in 15 years and you’ll have paid the bank much less interest than if you made the minimum 30 year payment. If you go this route, then you can always make the minimum 30 year payment if you have unforeseen expenses or lose your job. The only downside is that you won’t get the lower interest rate that comes with a 15 year term mortgage.

The bottom line

Many people would be better off if they opted for a 15 year fixed rate mortgage instead of a 30 year mortgage. It gives you a lower interest rate on the mortgage and the shorter team means that you’ll pay considerably less interest to the bank over the life of your loan. The main factors for it to be advisable for you is that you’ll have to be able to afford the higher monthly payment and still put money toward important things like retirement, your kids college. Of course you’ll need a stable job, at least 6 months of living expenses in the bank, and not carry credit card debt month to month as well. Your age is an important factor and you’ll thank yourself if you don’t have a mortgage payment during retirement.

An important dimension of a mortgage is the price of that mortgage. It’s easy to understand that a 3.5% interest rate is better than a 3.75% interest rate. An important concept that mortgage loan officers need to explain to borrowers is that borrowers can choose what interest rate they want (within a range), and there is a cost or credit associated with which interest rate the borrower chooses. And after that is understood, then this article will explain why although price is an important factor in choosing who to work with, it’s not the only factor and may not be the most important factor, when deciding who to work with.

Say for example:

• A 3.5% interest rate might come with a cost of 1% of the loan amount. This means that on a $100,000 loan the bank would ask you to pay them $1,000.
• A 3.625% interest rate might come with no cost, or what the industry calls “par” pricing.
• A 3.75% interest rate might come with a credit of 1% of the loan amount. This means that on a $100,000 loan the bank would pay you $1,000, which you can use toward offsetting your closing costs.

The reason that there are these “tiers” to pricing is that the lower the interest rate you get, the better off you are, and the less money the bank makes in interest off your loan, so they will ask that you pay an upfront charge for the right to have a lower interest rate. And as the interest rate increases, the more money the bank makes in interest off your loan, so they are willing to give you money upfront as an enticement for you to accept that higher interest rate.

To continue with our example above, if bank A is charging $1,000 on a 3.5% interest rate and bank B is charging $1,250 on the same interest rate, then bank B is considered to have worse pricing. So does this mean that you should choose bank A over bank B? Not necessarily, and in many cases, choosing the more expensive bank may be in your best interest. The process of getting a mortgage loan is not a commodity. If we were talking about buying an ounce of gold, then yes, you should buy from whoever charges less for an identical ounce of gold. However, the mortgage process is more complex than that.

The first thing to consider is the knowledge and experience of the mortgage loan officer you are deciding to go with. As it’s typically most people’s largest financial transaction and much of the public’s wealth is held in real estate, working with someone with the knowledge and experience to guide you through the mortgage loan process’s intricacies, answer all of your questions, and educate you so that you can make the best financial decisions is invaluable; not to mention the fact that the best mortgage loan officers can advise you against making poor decisions, which could destroy your wealth. To illustrate, there are websites out there that can help you draw up a trust for $250. However, why are there attorneys that charge $5,000 or more that have waitlists to also draw up trusts? It’s because these high level specialists add value to the process by using their knowledge to help you optimally achieve your goals, while at the same time they have the expertise to advise you against certain actions that are not in your best interest. In the same way, a mortgage loan officer can add value by ensuring that you are optimally achieving your goals and not taking wrong turns along the way.

It is also valuable to work with someone you trust, like, and get along with. There is a lot of sensitive information handed over such as your social security number, income information, asset statements, FICO scores and much more. Having a sense of trust and comfort is valuable in these situations. In addition, since you will probably be dealing with this person over many conversations, emails, and seeing them face to face, it’s important that you like dealing with this person. It is not a positive experience if you are cringing every time you have to correspond with your mortgage loan officer.

Keep in mind that the overhead costs that all banks have is roughly the same. Though not always the case, it can be that when a bank advertises low interest rates, they make up the money by charging higher fees elsewhere. They can also make up for low pricing by having fewer employees. Though this reduces overhead costs, it can lead to a slower loan closing, or it can mean having staff that are either overworked or undertrained because of high turnover – issues that can mean more mistakes on your mortgage file. Banks that compete solely on price tend to have business models where each employee earns less per loan, and loan officers can make up for that by simply doing more loans. This can mean that your loan officer might not have the time to provide the service that is needed for you to have an customized experience where the sole focus is on you  optimally achieving your goals.

Finally, a lender who tries to win business by undercutting everyone else in the market is no good to anyone if they cannot close your loan. There are lenders out there who advertise the lowest interest rates, but if you read the fine print, then you’ll learn that they have many restrictions that exclude most borrowers or properties from qualifying for their loans, or if they do agree to do the loan, then they charge more fees, which after accounting for make them no longer the price leader. These lenders can cater to only a small group of people, but are good at getting you in the door by advertising jaw dropping low rates. These are the same lenders who have very few loan programs, and if you don’t fit into one of their programs, then they’ll deny your loan leaving you searching for someone else who can help you.