Imagine getting a $55,077 mortgage credit rather than paying a mortgage fee to get a new loan. A $55,077 mortgage credit was what I was quoted for a $4.125 million, 10/6 ARM at a 3.625% rate. Surely receiving a large credit is better than paying a mortgage fee right? Not necessarily.
The higher the mortgage rate you are willing to pay, the greater the mortgage credit you receive. The reason is that the lender is making a higher interest rate spread off your loan.
Taking out a new mortgage at a lower 3.375% rate with only a $3,514 credit might be a more optimal decision for a well-qualified borrower. By saving $576 a month in mortgage payments, you will break even in 89 months.
You get 89 months by taking the difference in the credit of $51,563 and dividing it by $576. If you plan to hold the mortgage for longer than seven-and-a-half years, then you will come out ahead all things being equal. If you invest the difference with positive gains, you will break even sooner.
This is the traditional argument for why getting a lower mortgage rate with less credits may be better. However, there is another argument for why paying a small mortgage fee is better than getting a large credit. And I'm not sure most people know this. I didn’t until recently.
Why It May Be Better to Pay A Mortgage Fee Than Receive A Credit
Curiously, I learned from a Citimortgage officer you may not receive the entire mortgage credit, especially if it more than covers all fees. Instead, some or all of the credit overage may be wasted. As a result, it may be better to choose a mortgage rate that comes as close to a no-cost mortgage as possible.
Follow this dialogue to understand why paying a mortgage fee may be better than receiving a credit. I asked the Citimortgage officer to clarify his rate snapshot above.
Excess Credit Stays With The Lender
Me: A $55,077 credit looks so juicy if I go with a 3.625% mortgage rate. If the fees are still $11,955, would I get a $43,122 cash credit ($55,077 – $11,955)? Or would I actually get the full $55,077 credit after all fees? If not, where does the credit go? To a lower loan amount? Or cash back in my checking account?
Mortgage officer: In “theory” you could get that credit, but there is a restriction that the credit must cover “hard” / “legit” / “real” closing costs. Anything over that would stay with the lender. So in the real world, the way we would structure it would be to have a credit that came closest to but does not exceed the total closing costs.
In this case it would be the 3.375% note rate with a $3500 credit, meaning there would remain $14,000 and a bit of closing costs as the total cost to take out the loan would be a bit over $17,500. If you took the 3.5% note rate with the $29,000 credit, it would pay 100% of your closing costs. However, you would be leaving $11K to the bank as the costs are only $18,000.
Mortgage Credit Doesn't Get Applied To Reducing Mortgage Amount
Me: Got it. Would the remaining $11,000 credit balance on taking out a 3.5% note with a $29,000 credit be used towards lowering my mortgage balance by $11,000? If not, do I really just lose that remaining $11,000 of credit?
Mortgage officer: No, the “credit” would not go to reducing the loan amount. It is a total loss if it is not applied to closing costs. Even though we refer to the credit in terms of dollars and cents, it is more of an accounting measurement rather than “real” dollars and cents. It is a way for us to “price” the different note rates.
The notes at higher rates are more “valuable” but not so much in hard dollar terms. The intrinsic value is obtained by providing the customer with a range of options.
I would suggest you take the 3.375% in this situation. Usually, the dollar amount difference between note rates is not this extreme, but this is a large dollar amount loan, so minor rate differences result in huge differences in amounts of credits or points.
BTW all of these figures are hypothetical as the rates are old. When it comes time to lock rates, we might land at a place where we could cover, let’s say, 80% of the closing costs without “leaving money on the table.”
Paying A Small Mortgage Fee Is Better
It's hard to qualify for a new mortgage or refinance nowadays. Lending standards have become incredible strict since the previous financial crisis. However, if you are able to get a mortgage, then paying a small fee is better than receiving a large credit.
Ideally you want to choose a mortgage rate that provides just enough credit to cover 100% of the cost to take out a mortgage or refinance a mortgage. Every dollar of mortgage credit you receive above the mortgage cost is wasted.
The next best thing is if the mortgage credit can cover at least 70% of the cost of the mortgage. Even if you have to pay thousands of dollars at closing, at least you are paying a lower mortgage rate and are not wasting money.
Even if you have to pay even more in mortgage costs, you may eventually still end up ahead if mortgage rates stay at the same level or increase and you hold onto your mortgage for a long enough time period.
Banks Will Always Profit Off Your Loan
Please know there is no free lunch when it comes to taking out a new mortgage or refinancing your existing one. The bank will find a way to make money off your loan. Further, it won't reveal exactly how much money it will make off you.
A good lender will give you various mortgage rate and fee options. From there, it's up to you to decide which rate with which fee structure best suits your situation. If you are unsure about anything during the process, please ask your mortgage officer for clarification.
In the past, I would always try to get a “no-fee” mortgage. Any overage credit I had would be paid to me by check or electronic credit. but the amounts were less than $2,000. Now, if I ever get another mortgage, I will aim to get a “little-fee” mortgage to ensure fewer dollars goes to waste.
Thoughts On Buying Real Estate Today
At this time, I don't think it's wise to take on debt to buy property. Instead, I think it's much better to be surgical in your real estate investing by dollar-cost-averaging into public REITs or private real estate funds without leverage.
My favorite real estate investing platform is Fundrise, as they offer funds focused on single-family and multi-family rental properties in the Sunbelt. With Fundrise, you can invest as little as $10 at a time.
In addition, you can check out individual real estate opportunities in fast-growing cities with CrowdStreet. CrowdStreet occasionally offers special real estate funds as well.
If inflation finally shows clear signs of turning, it will be risk on again in stocks and real estate. You want to be well-positioned for an eventually turn around. Real estate has proven to be a great long-term builder of wealth.
For similar discussions on choosing between two financial options, purchase a new copy of my book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. I tackle some of life's biggest dilemmas so you can make more optimal decisions and lead a better life.
I had a situation like this in 2017 and didn’t know till late in the game. I prepaid a year of hoa fees and one time pmi instead of monthly and got a really small credit lender was ok with at close.
I love how your brain works Sam. I wouldn’t even think to ask questions like yours without reading your articles. Very helpful to understand more about how different loan options work. I’m sure a lot of people just assume that no fees and higher credit is always better because it sounds better. But it definitely takes looking at the actual numbers and how long you plan to hold the loan to really decide which is better. Super helpful post, thanks!
Hey Sam, hope all is well. I love your articles and have been reading them for years.
I have a couple questions/comments about the logic behind choosing to finance with a fee or with a credit. It seems that the Citi mortgage officer must have left out some important details.
In your example above, if the closing costs/fees are 18k and you lose any credit you would have received that is greater than 18k why would anyone choose the higher 3.625% rate with the 55k credit compared to the 3.5% rate with the 29k credit? According to the info provided by the mortgage officer, any option that includes a credit over 18k would result in a no cost closing loan with a $0 credit. There would never be a situation where someone would choose a higher interest rate if they weren’t going to receive a bigger credit for it.
I went through the refinancing process on my last house but had to cancel at the last minute because of unexpected circumstances. But I went through the very same process you describe above when trying to choose my rate. However, it was described to me that the credit you see in the chart is the credit after closing costs are figured in. It’s the dollar amount you actually receive via a check after the process was complete. One of our mortgage officers must be wrong or it’s more complex than we think :)
Look forward to your reply!
I asked him straight up whether I would get the credit overage after paying all fees, either as cash or as credit towards paying down the loan. He said no. He said it would be a total loss.
However, I absolutely did get some credit back at closing for many of my prior refinances. Hence, there must be some practice where providing a credit in terms of cash after closing is fine if it’s under a certain amount.
As consumers, we don’t know exactly what all the fees and credits are behind the scenes. But this mortgage officer was very transparent and sent me the snapshot of all my options and NOT explain in detail what happens.
Please send this post to your mortgage person for their thoughts.
And the bottom line is for all borrowers to ASK what happens to the credit overage.
The rule you reference of being able to provide the credit if it’s under a certain dollar amount may very well be the discrepancy. My credit would have been less than 2k I believe.
It’s just weird they would even provide those higher credit options. Feel sorry for the unexpected home buyer/refinancer that isn’t advised properly and chooses one of those options.
Appreciate the reply!
I’ve never seen the options laid on in such detail before. I usually ask what X type of mortgage rate is and what the fees will be.
This example takes it a step further. So it’s a good lesson for all borrowers to know – to keep asking for details.
In this example, the 3.375% option and then the 3.5% option (no fees) are best. But surely there is something the 3.5% borrower can do to salvage SOME of the credit overage.
Fascinating stuff for us to mull over. I always thought the credit overage could be used to lower the loan balance, bc I coulda sworn I did this over a decade ago! Alas, perhaps things have changed.
Your arguments ignore the time value of money.
Investing that $55,077 mortgage credit and earning 8-10% over the life of the mortgage will make you significantly better off than foregoing that money at T=0. Assuming an 8% return grows that sum to ~$175k over 15 years.
Plus, you have the added benefit of paying back in dollars that are worth less and less each year due to the effects of inflation.
Sounds good. But how would you go about investing the $54,077 credit if it is not cash credited to your account and accessible?
Maybe I didn’t make my post clear enough. The credit overage beyond closing costs is or is mostly a total loss. I did bold those two words though.
My bad. Yes, if even a single dollar of the mortgage credit is lost, then a higher mortgage credit makes no sense. During my last cash-out refi, I confirmed with the lender that any net lender credit would be paid to me at closing. It was. So I chose the rate that gave me a $2k net lender credit at a rate of 3.375%. I always have chosen the option that gives me as close to $0 out of pocket as possible. On previous refinancings (with a different lender) I was told that any portion of the lender credit that cannot be applied to closing costs is lost. So this appears to vary by lender.
To clarify, did you get the credit overage in cash?
$2k lender credit to be used for closing fees etc. But if the fees were less than $2K, what happened to the balance?
Yes, the $2k was a net lender credit. The lender credit was $4,327 and closing costs were $2,188, resulting in a $2,139 net lender credit that was added to my cash-out amount and paid to me at closing.
Don’t think you read the article or understand that a higher lending credit means paying a higher mortgage rate.
You need to bake the higher rate into your calculation as well.
Sam wrote: “By saving $576 a month in mortgage payments, you will break even in 89 months. You get 89 months by taking the difference in the credit of $51,563 and dividing it by $576.” The $576 a month paid back in 5, 10, 15 years is significantly less than any amount you could get as a net lender credit today. So this effectively pushes out the breakeven date. Lender credits that at least get the borrower’s out of pocket cost to $0 are therefore worth it. If any net lender credit is paid out at closing (earning 8-10% over the life of the loan) that’s also worth it. Most people with no finance background struggle with these concepts.