Selecting the Wrong Combination of Interest Rate and Lender Fees

Lenders generally offer borrowers alternative combinations of interest rate and points: low rates are offered when the borrower pays points to the lender, high rates are offered when the lender pays points to the borrower. Points paid by the borrower are an upfront cash outlay, whereas points paid by the lender are used to pay the borrower's settlement costs.
In addition to points, which are expressed as a percent of the loan, lenders also charge fixed-dollar fees. Since these vary a little from lender to lender, we simplify the decision process by adding all lender fees together.
Borrowers frequently don't choose the combination of interest rate and total lender fees that is best for them for the same reasons they often don't select the best type of mortgage: their own ignorance, poor advice, and inadequate disclosures. Some borrowers don't understand that there is a choice to be made, and their loan provider (loan officer or mortgage broker, henceforth LP) may have no interest in taking the time to explore an issue that can be avoided.
One way to avoid it is to simply steer the borrower toward the rate that carries zero points -- or close to it. While steering borrowers toward a mortgage that carries a larger commission for the LP is now illegal, it is not illegal to steer a borrower toward the mortgage that involves less time and effort for the LP.
On this site, borrowers take control of the process themselves. The issues are not that complex, and are summarized in the table below.
Borrower Is Income ShortBorrower Is Cash Short
Borrower Expects to Have Mortgage 4 Years or Longer1. Select High Fees, Low Rate2. Select Rate At Zero Fees
Borrower Expects to Have Mortgage Less Than 4 Years3. Select Rate at Zero Fees4. Select Negative Fees, High Rate
Borrowers with long time horizons, defined for convenience as more than 4 years, profit from paying points that reduce the rate because they will enjoy the benefit of the lower rate for a long period. The higher fees can be viewed as an investment that earns a high rate of return. The longer they hold the mortgage, the higher the return.
If the borrower with a long time horizon is also income short, the case for paying points is clear-cut because the lower rate reduces the payment. This is box 1 in the table.
Borrowers with short time horizons will profit by selecting a high-rate mortgage on which the lender pays some or all of the borrower's settlement costs. The profit arises from the short period over which the borrower pays the higher rate needed to reduce the upfront cash outlay.
If the borrower with a short time horizon is also cash short, the case for paying a higher rate is clear-cut. The borrower reduces the cash outlay and doesn't pay much to do it. This is box 4 in the table.
But some borrowers may be forced to compromise. If the borrower has a short time horizon and is income-short, as in box 3, he is in a conflict situation. Though he would profit from paying a higher rate, he can't afford it. A compromise is necessary, perhaps by selecting the rate close to zero fees.
Similarly, the borrower with a long time horizon but cash-short, as in box 2, is in a conflict situation. Though he would profit from paying points, he can't afford it. Some kind of compromise is also necessary in this case.
The rate of return from paying points can be calculated from Mortgage Points Calculator: Rate of Return on FRMs and Mortgage Points Calculator: Rate of Return on ARMs.

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