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Putting all of these expenses together can add up to quite a large amount of money, as
this example will illustrate:Example 10.2.9 Drew and Joanne are buying a house for $128,550. They will make
a minimum 3% down payment, and closing costs will total $2,100. Annual property
taxes are $2,894 and homeowners’ insurance is $757 annually. How much money will
they need up front?
Their down payment comes to (0.03)($128,550) $3,856.50.The closing costs are given, and they will also need $2,894 $757 $3,651 for prepaids.
Putting this all together, we get a total of:$3,856.50 $2,100 $3,651 $9,607.50Ouch! Even if Drew and Joanne can comfortably manage the monthly payment on this
loan, the up-front costs present a difficult barrier to overcome. People who are selling one
house and buying a new one often will have enough equity in the home they are selling to
cover these costs easily, but first-time home buyers don’t have that advantage.
Fortunately, special programs, both government-sponsored and others, will sometimes
provide ways to get around this hurdle (for example, “no-closing cost” loans are some-
times offered, under which the lender shoulders the closing costs, often in exchange for
a higher interest rate on the loan). Sometimes lenders will require less than a full year of
taxes and insurance up front, and instead make up any escrow deficits by requiring higher
escrow payments during the first year.An Optional Up-Front Expense: Points
Lenders often offer the opportunity to “buy” a lower interest rate by paying points. Points
are a fee paid to the lender up front, in exchange for a lower interest rate. One point is equal
to 1% of the amount of the loan.
For example, a lender might offer the following choices for a 30-year fixed loan:Points Interest RateNone 7.5%
2.5 6.25%A borrower who can afford to come up with the money to pay points up front can poten-
tially end up saving quite a bit of money, as demonstrated in the following example.Example 10.2.10 Suppose that Drew and Joanne (from Example 10.2.9) are offered
the mortgage choices shown above.(a) How much more would they have to come up with if they chose to pay the
points?(b) What would their monthly mortgage payment be with each of the options
offered?(c) How much would they save over the 30-year life of the loan if they paid the
points?
(a) The price of the house is $128,550. Drew and Joanne are making a $3856.50 down
payment, and so they will be borrowing $128,550 $3,856.50 $124,693.50.
Since each point is 1% of the loan, 2.5 points is 2.5%, or (0.025)($124,693.50) $3,117.34.
(b) Using the present value annuity formula with PV $124,693.50 and a 7.5% interest rate
for 30 years gives that the monthly payment for the loan with no points would be $871.88. Using
the 6.25% rate that they would have if they paid points gives a monthly payment of $767.76.
(c) Looking at the total payments over the life of the loan, we see that:
No points: (360)($871.88) $313,876.80
Points: (360)($767.76) $276,393.6010.2 Mortgages 443