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Your Mortgage : Lower Rate Doesn't Always Mean Lower Cost

March 05, 1995|KENNETH R. HARNEY | SPECIAL TO THE TIMES

WASHINGTON — If you plan to shop for a mortgage in the next few weeks, keep two rules in mind that are especially pertinent to the highly competitive 1995 market:

--The lowest-rate quote you hear probably isn't your lowest-cost alternative.

--Federally mandated APRs--annual percentage rate truth-in-lending quotes that calculate the effect of up-front lender fees--don't necessarily tell you what you think they do.

Here's why both rules are of extra importance at the moment: Rates have edged down gradually in recent weeks and have cracked the 9% barrier for 30-year, fixed-rate money in many parts of the country for the first time in months.

You can probably find 8 1/2% or even lower fixed-rate quotes and deeply discounted teaser-rate adjustables below 6%. Low quotes like these typically come with higher "points" attached as part of the deal. Each point is equal to 1% of the mortgage amount, payable at or before closing.

But do you want a low-rate, high-point package in an environment like this spring's, or a low or no-point, higher-rate alternative? Look at this real-life scenario that you could confront as a shopper for a $150,000, 30-year, fixed-rate loan. Lender A quotes 9% with zero points. Lender B has the lowest rate anywhere in the market--8 1/2%--and charges 3 points. Lender A's advertised APR is 9%. Lender B's APR is clearly better--8.83%.

Isn't the smart shopper's choice obvious? Not at all. The principal and interest payment on the 9% loan comes to $1,206.93 a month. Payments on the 8 1/2% mortgage are $1,153.37--an attractive $53.56 a month lower. Sounds good, but now figure in the true cost of the $4,500 in points. Putting aside any other features of the two loans, it will take you 84 months--a full seven years--to recoup the upfront costs of the 8 1/2% mortgage ($4,500 divided by $53.56). That is, on a cash-out-of-pocket basis, your 9% loan will be cheaper than the 8 1/2% loan for the first seven years.

Put another way, if you had to sell or refinance any time in the next seven years--up until 2002--you'd be smarter to go with the higher rate, higher APR zero-point alternative.

What about taxes? After all, you can deduct the $4,500 in points against your federal and state tax liabilities, thereby lowering the effective cost. True. Say you're in a combined federal and state bracket of 36%. You get to deduct $1,620 ($4,500 times .36) of your points on your tax returns in the year of the loan.

The net cost of the points then becomes $2,880, which you can't fully recoup for the first 53 months--almost 4 1/2 years down the road.

Here's still another scenario to contemplate. Say that two or three years from now--perhaps as the result of the mild recession some economists foresee on the horizon--long-term rates have moderated. Instead of a 9% zero-point market you can get an 8% zero-point loan. Having laid out $4,500 in cash to get your 8 1/2% rate, you're unlikely to want to refinance into a new loan so early. Moving from a zero-point 9% loan, on the other hand, to a zero-point 8% loan, will save you even more money on monthly payments. Having invested nothing in points the first time, you'll be free to do it again.

David Ginsburg, whose Gaithersburg, Md.-based firm, Loantech Inc., has created software "rates and points" cost comparisons for competing mortgages, says the zero-point 9% option would save you $1,428.58 in total, after-tax outlays if you decided to refinance after three years. The key to all this, he says, is the interaction among points, rates, tax brackets and the length of time you stay with the loan. He emphasizes the last factor.

"It's not how long you're going to live in the house," he said, "it's how long you're going to keep the loan." The typical homeowner who stays in the same house for 10 years refinances once or twice along the way, either for a lower rate or to cash out some equity.

Another popular misconception among mortgage shoppers is that lenders' APRs are an accurate guide to the most cost-effective loan option. Not necessarily so. That's because all an APR disclosure does is to measure the cost of credit over the full 30- or 15-year term of the loan. This involves spreading the cost of the points over as many as three decades.

But since the average mortgage is paid off within seven to eight years, the APR tends to mask the impact of points on consumers' true costs. Three points on a $150,000, 8% mortgage adds just .33% to an APR stretched over 30 years. But pay off that loan in the first couple of years and your true APR--the real rate you pay--could be in double digits.

How bad can it get? Dave Hershman, an author and regional vice president of Chase Manhattan Mortgage Corp., estimates, for example, that an 8% loan with 4 points paid off in two years carries an APR of 12.1%.

So what if you see the deal of the year this weekend--8% fixed rate with just 5 points? Apply for it at your peril. If you get transferred this fall and have to pay it off six months after closing, guess what your APR would be on a $100,000 loan? Try 26% on for size.

Distributed by the Washington Post Writers Group.

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