Case Study: Cheaper Rates vs Lower Closing Costs
Case Study:
Cheaper Rates vs Lower Closing Costs
Securing a loan is a significant financial decision, and understanding all the costs involved can help you choose the best option for your situation. When comparing different loan structures, the upfront costs and long-term interest rates are two of the most important factors to consider. In this blog post, we'll break down two loan options using the same $300,000 loan amount, focusing on the differences in origination fees, lender fees, interest rates, and the overall financial impact of each loan.
Let’s dive in and see how The Lower Rate compares to Lower Closing Costs, especially when considering interest-only payments for both scenarios.
Scenario 1: 2 Points Origination, $2,000 Lender Fees, and Interest-Only Payments at 7.5%
In Option 1, the loan includes the following terms:
Origination Fee: 2 points (2% of the loan amount)
Lender Fees: $2,000
Title and Escrow Fees: Paid separately
Interest Rate: 7.5% (interest-only payments)
Let’s break down these components:
Origination Fee (2 Points):
The 2-point origination fee means that you’ll pay 2% of the $300,000 loan amount upfront, which comes out to $6,000. This fee covers the lender's costs for processing and underwriting the loan.Lender Fees ($2,000):
These are additional fees for services like credit checks, document preparation, and other administrative costs. You’ll pay $2,000 on top of the origination fee.Title and Escrow Fees:
These Fees typically are .5% of the total purchase price, so for this example this loan is 75% LTV, so the purchase price would be $400,000, and the Title and Escrow fees should be $2,000 or less.
Interest Rate (7.5% Interest-Only Payments):
The loan offers a 7.5% interest rate with an interest-only payment structure. With an interest-only loan, you are only required to pay the interest for a set period (usually 5-10 years), and you don’t pay down the principal during this time. Your payments in this case would be based solely on the interest accrued each month.Monthly Interest-Only Payment:
For a $300,000 loan at 7.5% interest, your interest-only monthly payment would be:Dividing this by 12 months:
22,500÷12=1,875 per month22,500 \div 12 = 1,875 \text{ per month}22,500÷12=1,875 per month
So, your monthly payment would be $1,875 for the interest-only period, plus total closing costs of $10,000 in Closing Costs.
Scenario 2: $0 Origination Fee, $0 Lender Fees, Lender-Paid Title and Escrow Fees, and Interest Rate of 9%
In Scenario 2, the loan is structured differently:
Origination Fee: $0
Lender Fees: $0
Title and Escrow Fees: Paid by the lender
Interest Rate: 9% (interest-only payments)
Let’s look at the breakdown of this option:
Origination Fee ($0):
There is no origination fee in this option, so you don’t need to worry about paying an upfront fee of 2% of the loan amount (which was $6,000 in Scenario 1).Lender Fees ($0):
Option 2 doesn’t charge any lender fees either, so you won’t have to pay the additional $2,000 in administrative fees that come with Scenario 1.Title and Escrow Fees (Lender-Paid):
The lender will pay the title and escrow fees for you, which can amount to thousands of dollars. This is a significant advantage if you’re trying to reduce your upfront costs.Interest Rate (9% Interest-Only Payments):
The interest rate for Scenario 2 is 9%, which is higher thanScenario 1’s 7.5%. However, this loan also has an interest-only payment structure, meaning you’re only paying the interest for a set period, just like in Option 1.Monthly Interest-Only Payment:
For a $300,000 loan at 9% interest, your interest-only monthly payment would be:300,000×9%=27,000 per year300,000 \times 9\% = 27,000 \text{ per year}300,000×9%=27,000 per year
Dividing this by 12 months:
27,000÷12=2,250 per month27,000 \div 12 = 2,250 \text{ per month}27,000÷12=2,250 per month
So, your monthly payment in Option 2 would be $2,250 for the interest-only period.
Upfront Costs Comparison:
Let’s now compare the upfront costs for both options:
Option 1:
Origination Fee: $6,000
Lender Fees: $2,000
Title and Escrow Fees: $2,000
Total Upfront Costs (excluding title and escrow): $10,000
Option 2:
Origination Fee: $0
Lender Fees: $0
Total Upfront Costs (excluding title and escrow): $0
So, Option 2 offers significant savings on upfront costs, as you avoid both the origination fee and lender fees. The lender also picks up the title and escrow fees, so your total costs at closing are substantially lower in Option 2.
Monthly Payment Comparison:
Next, let’s look at the monthly interest-only payments:
Scenario 1:
Monthly Payment: $1,875
Scenario 2:
Monthly Payment: $2,250
In Scenario 1, your monthly interest-only payment is $1,875, while in Scenario 2, your monthly payment increases to $2,250 due to the higher interest rate. That’s a $375 difference per month, which may add up over time.
Long-Term vs Short-Term Financial Impact:
While Scenario 2 provides immediate savings on closing costs, the higher interest rate means you'll pay more over time in interest. Let’s look at the potential long-term financial impact:
With Scenario 1, although you pay higher upfront costs, the lower interest rate means that over the life of the loan, you could pay less in interest. Over a 30 year period the $375/mo would save you $125,000, ($365 x 360 Payments - $10,000 Initial Cost Difference). However to recoup your initial difference in closing costs would take you 27 Months. ($10,000 / $365/mo )
In Scenario 2, if you think that interest rates are going to be lower in the short term delaying the closing costs can be a cost saving advantage to reduce your out of pocket expenses.
Which Option Should You Choose?
Choosing between Scenario 1 and Scenario 2 depends on your financial priorities:
If you want to minimize upfront costs, Scenario 2 is the better choice, as it has no origination or lender fees and the lender covers title and escrow fees. However, you’ll pay a higher monthly payment due to the higher interest rate, which as long as you refinance in the 1st 27 months, you will actually come out ahead.
If you can afford the upfront costs and want to minimize long-term interest payments, Scenario 1 might be more advantageous. The lower interest rate of 7.5% will save you money over time, even though your upfront costs are higher. In this scenario, you would most likely expect interest rates to be going up in the short term.
Consider your future plans: If you plan to refinance or sell the property within a few years, Scenario 2 might be a good choice due to the lower initial costs. However, if you plan on holding the loan for a longer period, the lower interest rate in Scenario 1 could ultimately save you more money.
Conclusion:
Both options have their advantages and drawbacks. If you’re focused on saving money upfront, Scenario 2 will be your best bet. But if you’re looking to save on long-term interest costs and can afford the higher upfront costs, Scenario 1 may be the right choice.
Before making your decision, it’s important to carefully consider your financial situation, how long you plan to stay in the property, and your ability to handle monthly payments. Speaking with a mortgage professional can help you make the best choice for your personal needs.
Happy Property Investing!
