Low Rates Don’t Always Mean Lowest Cost: Learn when “Bigger” Is Better


You’ve been given two choices for a mortgage rate on your new home, both for loans of the same amount. One offers you 4 percent interest, which amounts to a principal and interest payment of $1,074 per month. The other option is a 4.75 percent rate, which amounts to principal and interest payments of $1,173 a month. The decision is obvious, right?

Not so fast.

Mortgage Rate A seems like the clear winner. It offers you monthly payments that are nearly $100-a-month less than those of Mortgage Rate B. So why on Earth would someone even consider the latter plan?

One piece of information that we withheld from you was the amount of cash the lender was able to toss back your way for use on closing costs. More often than not, these funds—also known as lender credits—are more readily available in cases of higher interest rates. For this example, let’s say that the 4 percent rate comes with no credit from the lender, and the 4.75 percent rate comes with $5,625 to be used toward closing costs.

$5,625 is a decent chunk of cash. But is it worth the monthly savings that you’ll collect from just sticking with the lower interest rate? You’ll need to do the math on a case-by-case basis, but here’s a simple formula for determining what it would take for a higher interest rate to be a better deal:

(Lender Credit / Monthly Savings) = Months Required For Lower Rate to Pay Off

Let’s hash this out. Take the lender credit, in this case $5,625, and divide it by the monthly savings of the lower rate…about $100 per month right here. Do the math and you’ll come to 56.25. This total is the amount of months it would take for the monthly savings of the lower rate to equal the lender credit offered by the higher rate.

This doesn’t give an easy “yes” or “no” answer as to which rate offers you a better deal in the long run. You need to take the number of months and apply them to your situation. Basically, do you plan on occupying the same home for 57 months (round up to the nearest whole month), or nearly five years?

If the answer is “yes,” then the lower interest rate is the better plan. You’ll be operating at a loss for those first 57 months, but if you live out your 30-year mortgage in the same home, you’ll be saving money for the next 303 months! That said, if you plan on moving again soon, the lender credits easily make the higher rate more worth your while than the lower ones.  

The average homebuyer, according to research, is expected to live in their new home for 13 years, or well more than the number of months it would take for the lower interest rate to become the better option. Still, that means there are a significant number of people spending a short enough time in a home to drag down the average from the 30-plus years that many are spending in one residence. If you think that there’s a chance you’ll be moving out sooner than later, make sure to speak with a lender to ensure that you end up with more money in the end…even if that means spending more per month now.

Primary Mortgage Residential wants to help you get into a new home, and we offer a variety of resources to help you understand the financial process and how to get the best deal on your way to that home. Use these options to get expert tips on shopping for loans.

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