- The Washington Times - Thursday, August 10, 2006

Following up on our discussion last week, a reader had written to ask if the best way to find the best mortgage rate is to compare the annual percentage rate (APR). To recap, the APR is the actual cost of the money borrowed, expressed as an interest rate, when taking into consideration any costs associated with the loan.

My advice to the reader was to forget the APR. Instead, he should seek out competent loan officers recommended from trusted sources and obtain a good faith estimate from each one.

Although there are myriad of reasons as to why the APR is not a good gauge to determine the best rate, the biggest reason is that it assumes that the borrower will hold the loan for full term. Such an assumption is not practical in this transient and dynamic world.

Let’s take this column and perform a simple mathematical exercise called the “payback period.” We have a borrower who wants a $300,000, fixed-rate mortgage amortized over 30 years. He can choose between two programs. First, he is offered a rate of 6.50 percent that carries no discount points or origination fees. After taking into consideration most of the standard closing costs, the APR is 6.75 percent.

He is also offered a fixed rate of 6 percent that carries the same standard closing costs, plus 2 discount points. One point is equal to 1 percent of the loan amount paid to the lender at settlement. The APR on this deal is 6.50 percent.

Is the 6 percent loan better because the APR is lower? I doubt it.

Let’s run the payback period.

The 6 percent deal, carrying 2 points, will cost $6,000 more than the no-point, 6.50 percent deal.

The principal and interest (P&I;) payment on a $300,000 loan at 6 percent is $1,799. At 6.50 percent, the P&I; is $1,896 — $97 more.

Our borrower needs to decide whether it’s worth it to sink $6,000 in upfront, nonrefundable fees into a mortgage that will drop his payment by $97 per month. To calculate the payback period, simply divide the cost ($6,000) into the savings ($97). The result is 61.85 months, or a little over five years. This means it will take our borrower 61 monthsto pay him back the $6,000 in points in the form of a lower payment.

It gets a bit more complicated. There’s a well-known financial term called “present value.”

Because the $6,000 is paid in the beginning, we have to assume that had our borrower not paid that money, he could have invested it. Most money market accounts are paying about 4 percent these days. Using simple interest, 4 percent of $6,000 equates to $240 per year, or $20 per month. Since this is interest he could have earned had he not paid the points, let’s deduct $20 from the payment difference, resulting in $77. Recalculating the payback period now gives us 78 months ($6,000 divided by $77).

There are tax issues, as well. Points on a house purchase are deductible in the year of the purchase.

But the extra interest paid by taking a higher rate will largely offset the tax benefits of points.

The bottom line is this: Is our borrower prepared to pay $6,000 in nonrefundable fees that won’t be recouped for almost seven years?

History tells us that he will either sell the property or refinance within seven years. The APR on the 2-point deal may be lower, but not if he pays off the loan before the end of the term.

The earlier the loan is paid off, the higher the actual APR will be.

Keep your costs down when you take out a mortgage. Avoid paying points.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected]pmcmortgage.com).

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