By: Brian Tilton
August 1st, 2024
A common misconception is that lenders offer a single interest rate at any specific point in time. On a daily basis, loan officers are asked, “What is your interest rate?”. In reality there is not a single rate per se, but rather a whole spectrum of rates from which the borrower can chose. Now of course interest rates differ by the loan program, the loan term, a borrower’s credit score, the loan-to-value (LTV) ratio, and an assortment of other factors. But for any given scenario, holding all those factors constant, there is still a whole spectrum of rates to choose from, each associated with a cost or a credit to the borrower.
To understand this properly, we must define a few terms:
- Lender Credit: Funds that are credited from the lender to the borrower. This credit can be applied to costs associated with a loan and/or home purchase. Some examples include title, escrow, prepaid property taxes, prepaid insurance, etc. So why would a lender give a borrower this seemingly free money? Because the rate selected by the borrower is an above market rate. Holding all things constant, the higher the rate, the higher the lender credit.
- Discount Points: Funds that a paid from the borrower to the lender at closing. Why would any rational borrower willing chose to pay discount points to the lender? Because they desire a below market interest rate.
- Par: This is the rate whereby there is neither a lender credit nor discount points. This is essentially that lender’s “market rate”
So where on the rate spectrum is it most advantageous for the borrower to select? The answer is . . . . . . it depends. While on the surface every borrower wants the lowest rate possible, depending on the circumstance, it may not make financial sense to pay discount points for the lower rate. For example, if a borrower is only expected to have the loan for a year or so, paying points for a lower rate is generally unwise. In this scenario, selecting a rate with enough lender credit to cover all costs may be a wise decision. On the other hand, if the general level of rates is at historically low levels, and the borrower does not anticipate paying off a loan for at least the next 10-15 years, paying discount points for the lower rate may be financially prudent.
Any worthy lender should discuss borrowers’ long-term objectives and be able to model various rate scenarios to advise the borrower on the optimal rate for their specific scenario.