Lenders may try to reel you in with ads for super low rates. Know what you’re in for and whether or not you could qualify before you bite, or you may find yourself pulled into a sales process that offers less desirable rates and terms that could take years to recover from.
SAMPLE CASE STUDY
Meet Marcus. He's buying a home.
Home price: $625,000 dollars | Financing $500,000 (80%).
Marcus is single and has been steadily building his career at a software company. He regularly deposits a percentage of his income into savings and doesn’t carry any credit card debt. He drives a nice car and has less than ten months left to pay it off. His gross monthly salary is $10,000 and his monthly minimum payments are $3,200 or 32% DTI (including his rent and student loan).
He sees an ad online for a 15-year fixed rate of under 2%! Will he qualify? What's the catch?
His profile is looking good!
It’s no surprise certain criteria must be met to get the best rates and loan options.
- High FICO score (740+)
- History of cash reserves in the bank
- Steady employment history
- An LTV (loan-to-value) ratio of 20% or more
- Low debt-to-income ratio (DTI)
A DTI of 36% or lower is ideal for conforming loans. Add up all minimum monthly payments and divide by monthly gross income. (ex. Rent/mortgage, home insurance, student and personal loans, car loans, credit card payments, and depending on loan type, may include child support, and alimony. NOT included: utilities, cell phone, health or car insurance, or any credit with less than ten months left to pay).
THE CATCH: The offer is way below market rate (the average interest rate being offered at a given time), and may involve upfront discount points*. While everyone loves a discount, these points actually cost you money; it’s another way of saying “buying down a rate”.
*One discount point costs 1% of your loan, but it only reduces the interest rate 1/8-to-1/4 % depending on both the lender and the borrower.
His story will help determine if the offer is right for him.
Although Marcus is single, he is planning to get married in the next year or so. He sees himself settling into his new home for a while, and then if all goes well, starting a family within the next four to five years. He figures that a growing family may outgrow the home. Since he has a large savings, he would consider paying more up front in addition to his downpayment. His main concern is how much the loan is going to cost him if he sells in five years.
Assessment
- Marcus would like to sell the home in 5 years
- He’s not worried about upfront costs
- Cares about cost at the end of 5 years
With Marcus’s excellent profile, he would have a lot of options. We compared the offer he found against a 15-yr fixed market-rate loan, a conventional 30-yr fixed discount rate and a 30-year market rate.
We surprised Marcus with a better loan program.
Going in, Marcus was sure the lower rate over a shorter period of time would be the right choice for him since his goal was to sell his home in 5 years. He soon discovered that a longer term loan was his best bet. The total costs are close whether he buys down the rate or takes advantage of a low-market-rate loan. Although it may at first appear he can save $131 a month by going with the 30-yr discounted rate, he actually would spend more per month when he averages in his upfront costs over five years.
Here are the rates we compared:
Keeping the home for the life of the loan
| Terms | Interest Rate | Upfront Costs | Monthly Cost | Total Payments |
|---|---|---|---|---|
|
15 yr, Fixed, 1.894 pts |
1.875% |
$9,470 |
$3,189 |
$583,461 |
|
15 yr Market Rate |
2.124% |
$0 |
$3,246 |
$584,311 |
|
30 yr Fixed, 1.479 pts |
2.375% |
$8,504 |
$1,943 |
$708,078 |
|
30 yr Market Rate |
2.875% |
$0 |
$2,074 |
$746,806 |
The rates in this table are for demonstration purposes only. Monthly payments do not include tax, insurance or HOA costs. Discount points were sampled from published industry rates. Actual rates, costs and terms are changeable and subject to a borrower’s creditworthiness.
ownership for 5 years
| Terms | Interest Rate | Upfront Costs | Avg Cost/Mo | Total Payments |
|---|---|---|---|---|
|
15 yr, Fixed, 1.894 pts |
1.875% |
$9,470 |
$3,347 |
$200,810 |
|
15 yr Market Rate |
2.124% |
$0 |
$3,246 |
$194,760 |
|
30 yr Fixed, 1.479 pts* |
2.375% |
$8,504 |
$2,085 |
$125,084 |
|
30 yr Market Rate |
2.875% |
$0 |
$2,074 |
$124,440 |
*When deciding to buy down a mortgage rate, it may be worth talking to a financial advisor about the potential loss of investment opportunities that could result from putting your cash out of commission for several years.
Depending on the situation, buying down rates by paying for discount points could be a good or bad idea; buyers generally don’t see benefits until several years into their loan cycle. This case study only examines a few different types of mortgage programs which were chosen by assessing the creditworthiness of the buyer, his profile and consideration for the things he cares about.
Before you buy your next home, contact us to see what types of loan programs might best suit you and your goals.
