If a lender is willing to reduce its fees for such items as loan origination, discount points and other one-time settlement charges, it may gain it back if it charges a higher interest rate.

Here is one rule of thumb which you can use to calculate the combine effect of the interest rate on a fixed-rate loan and the one-time settlement charges (paid by you) such as "points". While not perfectly accurate, it is usually close enough for meaningful comparisons between lenders. The rule is, that one-time settlement charges equaling one percent of the loan amount increase the interest charge by one-eight (1/8) of one percent. The 1/8 factor corresponds to pay back period of approximately 15 years. If you intend instead to hold the property for only five years and pay off the loan at that time, the factor increases to 1/4.

Here is an example of the rule. Consider only those charges that differ between lenders. Suppose you wish to borrow $60,000. Lender A will make a fixed-rate loan at 12.5 percent interest, but charges a two percent origination fee, a $150.00 application fee, and requires that you use a lawyer, for title work, selected by the lender at a fee of $300.

Lender B will make a fixed rate loan at 13 percent interest, but has no additional requirements or charges. As part of that 13 percent interest, though, Lender B will not charge an application fee and will absorb the lawyer?s fee. What are the actual charges of each case?

Begin by relating all of Lender A?s one-time charges to percentages of the $60,000 loan amount:

2 percent origination fee = $150 application fee = $200 lawyer?s fee = Total =

2 percent of loan amount 0.25 percent of loan amount 0.5 percent of loan amount 2.75 percent of loan amount

Since each 1 percent of the loan amount in charges is the equivalent of 1/8 percent increase in interest, the effective interest rate from Lender A is the quoted or "contract" interest rate, 12.5 percent plus .34 percent (2.75 times 1.8), or a total of 12.84 percent interest.

Since Lender B has offered a 13 percent interest rate, Lender A has made a more attractive offer. Of course, it is more attractive is you have sufficient cash to pay Lender A?s one-time charges and still cover your down payment, moving expenses, and other settlement costs. This is simply a method to compare diverse costs on an equal basis. In the above illustration, Lender A does not receive $300 lawyer?s fee.

The calculation is sensitive to your assumption about the period of time you plan to own the home before paying off the mortgage. As indicated above, the factor increases to 1/4 if you expect to pay off the mortgage in five years. Applying this new factor to the above illustration, the effective interest rate for Lender A would be 12.5 percent plus .69 (2.75 1/4) for a total of 13.19 percent interest. Lender A?s offer is no longer more attractive than Lender B?s which was 13.0 percent.

In doing these calculations you should also be careful as to which onetime fees you place into the calculation. For example, if Lender B in the above illustration did not include in this charge a legal fee but told you that you had to secure legal services in order to obtain the loan from him, you would have to add to Lender B?s interest rate the legal fee that you had to incur.

You can use this method to compare the effective interest rates of any number of lenders if you are shopping for a fixed-rate loan. If the lenders have provided Truth-in-Lending disclosures, these are an even better comparative tool. You should question lenders carefully to make sure you have learned of all the charges they intend to make. The good faith estimate you receive when you make the loan application is a good checklist for this information, but is not precise. Thus, you should ask the lender how the charges and fees are computed.

Copyright © 1997-2007, Prime Lend America Mortgage Corporation. - All rights reserved.
Please Read our Privacy Statement
Equal Opportunity Lender and Employer
Loan programs, rates and fees subject to change without prior notice.
A federal approved Lending Institution

Design and Hosting by DMNI