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.