Out of pocket money you pay the lender is a tough topic for most American families today. Generally, the more you’re willing to pay out of pocket, the better the offers from lenders get. Give, and you shall receive. Lenders like to get their income upfront, and you can save a lot over the long term.
We’re going to discuss:
- Loan discount points,
- Prepaid taxes and insurance,
- Origination fees,
- Title & Escrow fees.
This is not a full list of costs you can pay out of pocket, but I included the most important ones.
Purchase vs. Refinance
Before moving forward, we need to distinguish between two types of transactions: purchase and refinance. In a refinance where you have plenty of equity in your home, you will have an option of including some or all of 1-5 in your new mortgage. In a purchase, you won’t be able to include any of these in the loan because any funds used to cover 1-5 will take away from the money you’re using toward the down-payment. However, you’ll have an option of giving the lender more or less money toward the down-payment and loan discount points. Sometimes, the less out of pocket money you spend, the better, due to your personal financial situation. Sometimes not.
Loan Discount Points
These are the fees you can pay your lender, out of pocket, to bring down your interest rate. Let’s use a $100,000 loan amount as an example, with a fictional rate sheet for a 30 year fixed loan. You loan officer might give you the following options:
- Interest rate of 5% with $1000 credit from the lender toward your closing costs.
- Interest rate of 4.75% with $0 in discount points.
- Interest rate of 4.375% with a cost of $1000 in loan discount points, out of pocket.
Here are the steps to running a discount point analysis:
- Calculate the periodic payment for each interest rate,
- Multiply the periodic payment by the number of periods in the loan,
- Subtract the products from each other and compare to the amount of out of pocket discount points.
You will need a mortgage calculator to do step #1. I also suggest comparing each loan scenario not only for the full term of the loan but for the amount of time you’ll most likely keep this loan. Since most people statistically payoff the loan by selling or refinancing within 7 years of origination, I suggest doing a calculation for 5 years and for 10 years, in addition to the full term. Below, I’ll give you an example using the full 30 year term.
- Periodic payment of $536.82 multiplied by 360 = $193,255.
- Periodic payment of $521.65 multiplied by 360 = $187,794.
- Periodic payment of $499.29 multiplied by 360 = $179,744.
We are going to use the zero discount point loan scenario #2 as our baseline.
The difference between product of #1 and #2 is $5,461 over 30 years. That means that you will end up paying $5,461 more by choosing loan #1, while you get $1,000 in credit from the lender (that can be applied toward reducing your closing costs). Doing further math, the bank will net $4,461 more from you over 30 years.
The difference between product of #3 and #2 is $8,050. That means you will pay $8,050 less to the bank over 30 years, but at a price of $1,000 upfront out of pocket. The bank will net $7,050 less from you in 30 years.
That’s how you do the math. The choice of which option is best for you is personal. Essentially, you’re choosing between borrowing $1,000 more from the bank or borrowing $1,000 less. Don’t forget to do the analysis for 5 and 10 years as well (60 and 120), to get a clear picture.
The down-payment amount is analysed in a similar way, but with additional nuances. Lenders adjust mortgage interest rates based on risk. The bigger the down-payment, the lower the risk, and vice versa.
Lenders release daily rate sheets that loan officers use to price your loan. The down-payment risk is separated into brackets (see below), based on the percentage of your down-payment in comparison to the purchase price and/or appraised value. The measure of this risk is quantified by applying a ratio called Loan-to-Value (LTV).
The way you calculate the LTV is by taking the loan amount and dividing by the appraised value. For example, $100,000 loan on a $150,000 home will have a LTV of 66%.
Interest rate risk brackets, that lenders use, are typically determined by the LTV, in the following (or similar) fashion:
There are exceptions to the rule, but generally, the lower the LTV, the lower the interest rate, and vice versa.
You will run the numbers the same way as in the loan discount points example above, with two exceptions:
- Instead of using the $1,000 for discount points, you’ll use the extra money toward the down-payment.
- You will add the monthly mortgage insurance payment (discussed below) to the periodic payment.
In the beginning of the discussion on the down-payment, I mentioned there’s an additional nuance to consider. I was referring to Mortgage Insurance (MI). Depending on the type of loan you apply for, there are various types of MI:
- Private Mortgage Insurance (PMI),
- Mortgage Insurance Premium (MIP),
- Borrower Paid MI (BPMI),
- Lender Paid MI (LPMI),
- Upfront Mortgage Insurance Premium (UFMIP).
There are a lot of variations of MI, but they all share one thing in common: any time your LTV is above 80%, MI will be required to be paid by either you (BPMI) or internally by your lender (LPMI). If paid internally by your lender, it will be reflected in a higher interest rate.
I won’t be discussing MI in detail, in this article, but keep in mind that it will be present if you put down less than 20% of the purchase price. You will be able to cancel MI once certain requirements are met (check with your lender), so make sure to factor MI into your analysis as well.
Thus, a bigger down-payment will not only yield a lower interest rate but also lower MI.
Prepaid Taxes and Insurance
Prepaid taxes and insurance is another place you might chose to invest out of pocket money. In some instances, such as on government loans or high LTV loans, prepaid taxes and insurance are a requirement of the loan. More commonly, you will have a choice of setting up an impound account (also called an escrow account) to pay your property taxes and insurance monthly.
Lenders generally give closing costs incentives to set up an impound account. Remember, impounds are not fees. Impounds are fund held for property tax payments made on your behalf by your lender.
Let’s set up a loan to use for our example. Again, the loan amount is $100,000 and the interest rate is 5%. The appraised value of the home is $150,000. We’re going to be using a purchase loan in this example, closing in the month of January. We’re going to estimate annual property taxes at $1,875 and insurance at $800 a year.
Impound Account Example (with out of pocket money)
Let’s look at an example where you set up an impound account so you get an idea of how it works.
First, the required impounds vary based on the month the escrow closes. In January, for example, lenders collect 7 months worth of impounds. They collect 9 months in September and 2 months in February. Lenders do that because they need to make sure there are enough funds in the impound account to pay for property taxes and insurance when they are due. You can request a Property Tax Impound Schedule from any Title/Escrow company to get the details. Here’s one I’m using for this example.
Mathematical Example for January
In our example, the amount of funds required to set up your impound account is $1,560.42. You arrive at that number by adding $1,875 and $800, then dividing the sum by 12, and multiplying the dividend by 7. Our calculation isn’t complete yet, because we need to factor in the incentive (i.e. lender credit) you receive for setting up an impound account.
Lenders typically give you 0.25 points as an incentive to set up an impound account. In our example, that would be $250 ($100,000 multiplied by 0.25%). Thus, the total out of pocket money needed to set up your impound account is $1,310.42 ($1,560.42 minus $250).
The lender will make your property tax and insurance payment for you. Essentially, you’re getting $250 to set up an impound account, in exchange for paying the lender for property taxes and insurance upfront. In this example, you would be getting a 16% return on your money by setting up an impound account ($250 divided by $1,560.42). However, you will also need to compare it to the costs and benefits of using that out of pocket money toward other concepts we’re discussing in this article, such as discount points.
Origination fees are completely lender dependent. There’s no method required to analyze these out of pocket costs. What you need to keep in mind is that each lender sets their fees differently. You need to compare these fees to each other, but also keep in mind that origination fees are only a small part of the big picture. For example, if Lender A is offering a loan with $2,000 in origination fees and $2,500 total out of pocket, while Lender B is offering a loan with $500 in origination fees with $3,500 out of pocket, then Lender A’s deal is better because the total charge is lower. However, remember that the other factors of the ATOMIC method must also be weighed in for your final decision. Out of pocket money should not be your only consideration (although, for some families this can be the only consideration; and that’s fine).
Title & Escrow Fees
Title and escrow fees are always paid out of pocket in a purchase transaction and sometimes paid out of pocket in a refinance. If a loan officer tells you title/escrow fees don’t have to be paid out of pocket, what they’re really saying is that the lender or seller is giving you credit to cover them. In general, you can look at title and escrow fees as out of pocket money.
Reducing title and escrow fees are one of the easiest ways to reduce paying money out of pocket, but it probably isn’t going to save you a whole lot of money because the profit margin on those items is rather small due to a lot of competition. A key thing to remember is that you can shop your own title/escrow fees in a refinance, but rarely can you shop title/escrow fees in a purchase in Southern California. In So. Cal. you’re usually required to use the title/escrow company of the seller’s choice.
What you can do is call around different title/escrow companies and get a few quotes from them, the same way you shop lenders. Some companies charge more than others, so you may discover that there’s a better deal out there.
This concludes the article on out of pocket money. We discussed loan discount points, down-payment, prepaid taxes and insurance, origination fees, and title and escrow fees. There are other costs we’ll discuss in a later article, so stay tuned for more ways to save money on your home mortgage.