On today’s show we’re talking about the true costs of borrowing.
Borrowers often look at the interest rate when it comes to figuring out the cost of borrowing. On today’s show we’re going to look at the hidden costs associated with signing a new loan.
Loans come in all shapes and sizes. Most of them come with some form of up-front fees. These fees can be inclusive of disbursements. In other cases, these direct costs associated with the loan are added to the up front fees.
These fees include a lender fee. On top of the the lender might charge you for preparation of the loan documents. In that case, the lender’s legal fees are passed on directly to the borrower. If the lender wants additional title insurance, you’re going to pay for that too.
The latest fee in the US for some insured loans include the Adverse Market Refinance Fee. This fee is an additional 0.5% of the loan amount and is added to the upfront fees.
This new fee was announced back in August and was supposed to be effective September 1. But an outcry from borrowers pushed the effective date of the new fee until December 1. A survey of a few mortgage brokers suggests that the additional fee might be added to the upfront closing costs, or in some cases, the lender will aim to recoup the fee by adding it to the interest rate over the term of the loan. The fee is ultimately charged by Fannie Mae to the lender and it’s up to the lender to collect the fee however they choose to do so. So the bank may choose instead to spread the fee over a 5 year term and increase the interest rate by 0.1% to cover the additional fee.
That fee sounds painful, but it pales in comparison to some of the back end fees that can be assessed for early termination of the loan.
It’s pretty common to have a sliding scale termination fee if you refinance before the end of the term of the loan. For example, if you have a 7 year loan you might have a termination fee of 5% of the loan principal if you terminate in the first year of the loan. That would drop to 4% in year 2, 3% in year 3 and drop to zero by year 5 of the loan. If you’re going to sign a new loan that is going to be at a lower rate than your existing financing, you want to look at the total difference in cost.
Let’s say that you have an origination fee of 1% for the new loan, and let’s say that you’re terminating your existing loan early and have a 2% pre-payment penalty to pay. You’re now looking at 3% in up front fees. In order for that new loan to make sense, the interest rate would need to drop sufficiently to result in a meaningful saving. But you also need to look at it from a cash flow perspective. The lender fees need to be paid up front. So let’s imagine for a moment that you’re looking at a $1M loan. Those 3% in fees come to $30,000 that you need to fund at loan closing. If you don’t have that much available in cash, you’re going to have a hard time closing the refinance.
You might have done the analysis which shows that over 5 years, a 2% annual savings in interest on a $1M loan would save you $100,000, minus the transaction fees of $30,000 for a total savings of $70,000. But you still need to come up with the $30,000 + additional closing fees in cash.
Remember that in today’s environment some lenders are looking for borrowers to escrow larger amounts for maintenance reserves and for interest reserves than in the past. This is all part of a more conservative underwriting environment. So you might be facing a larger cash infusion for the refinance than you might have previously considered.
We are in one of the lowest interest rate environments ever. But to take advantage of it, you may need to pay careful attention to the entire capital structure and ensure you don’t fall short.