Dear Dr. Don,
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I was given two quotes on refinancing a mortgage. One is at 4.125 percent with minimum fees including a $5,400 lender credit. The second quote is at 4 percent, but my loan amount increases by about $7,000. The higher rate would be about $7,000 more expensive at the end of the loan term. The monthly payments differ by just a couple of bucks.
Which is best: the lower principal or the lower interest rate? The impact of $7,000 seems small. I'm tempted to go with the higher rate because my principal would be lower. Help!
Thanks, -- Celestine Chooses
It depends partly upon how long you plan to be in the home. If you expect to be a short-timer, you'd want the lender credit and slightly higher interest rate. Someone expecting to be in the house for the long haul should opt for the lower interest rate.
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My guess is that you don't have the cash to pay closing costs, so you have two options: Capitalize the cost by adding it to the loan amount, or pay a slightly higher interest rate and accept the lender credit to cover most or all of your closing costs. What are the total closing costs on the loan with the lender credit? You'll want to review the good faith estimates on the two loans to see the closing cost differences. If they're both $7,000, then you'll need to bring $1,600 cash to closing on the loan with the lender credit.
You want to minimize total costs over the time you expect to retain the mortgage.
You can use Bankrate's mortgage payment calculator along with the calculator amortization schedule to determine the loan balances and interest expense over that horizon.
Here's a table showing a scenario for a $300,000 mortgage at the two interest rates you provided. I'm going to assume there's $1,600 in closing costs above the lender credit. That cost is capitalized by adding it to the loan balance. To make the monthly cash flows the same, I'm also going to assume that the difference in the monthly payments is used as an additional principal payment.
Mortgages: Lender credit vs. no lender credit
|Lender credit||No lender credit||Difference|
|Loan term (months)||360||360||0|
|Additional principal payment||$3.96||$0||$3.96|
|Total monthly payment||$1,465.66||$1,465.66||$0|
|10-year planning horizon|
|Total interest expense||$112,304.17||$110,746.55||$1,557.62|
|Net savings from lender credit||$2,284.59|
In this 10-year horizon example, the lender credit mortgage has the advantage, mainly because of a lower loan balance. While this is not your precise situation, it at least provides a framework for comparing your choices.
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