July 25, 2014

Yes, mortgage lenders in the US will pay rebates to borrowers. This is a potentially valuable option which, to my knowledge, is not offered anywhere else in the world.  But having options means having to make choices, and this is a difficult one that borrowers often get wrong.  

Rebates Defined: A rebate is a credit granted to a borrower by a lender that can be used to pay third party settlement charges and/or to fund the borrower’s escrow account.  Rebates are the opposite of points, which are payments made by the borrower to the lender, and are sometimes referred to as “negative points.”  Borrowers pay for rebates by accepting a higher interest rate.

 Combinations of Interest Rate and Points/Rebates: The price sheets lenders distribute to their loan officers, showing multiple combinations if interest rate and points/rebates, may or may not be shown to borrowers. However, borrowers have access to such data on various web sites, including mine.   

As an example, if on July 11, 2014 you had priced a fixed-rate mortgage on my site, you would have seen 17 combinations of interest rate and points. If the loan was for $300,000 on a single-family home valued at $400,000 and the borrower’s credit was excellent, the lowest rate of 3.5% was available with points of $13,134, at 4%, the points were $344, and above 4% the lender offered rebates: $10,499 at 4.5%, $17,731 at 5%, and $26,032 at 5.5%.  

Factors Affecting the Choice:  The best rate/fee combination for any borrower depends in part on whether the borrower‘s  greater deficiency is cash or income.  If she is cash-short, her preference should be to accept a higher interest rate to obtain the rebate that will help meet settlement costs. If she is income-short, her preference should be to pay points to lower the interest rate, which will reduce the mortgage payment and the ratio of payment to income.  

The best rate/fee combination also is affected by the borrower’s time horizon – how long she expects to have the mortgage. If her time horizon is short , the total mortgage cost is minimized by taking the largest rebate possible, but if her time horizon is long, she does best by taking the lowest interest rate possible. This is illustrated in the table below which shows total cost for just 3 rate/point combinations, and 3 time periods.

                 Total Cost of a $300,000 Fixed-Rate Mortgage on July 11, 2014

Interest Rate and Points/Rebate	Period the Borrower Holds the Mortgage
	3 Years	9 Years	15 Years
3.5%, Points of $13,134	$36,686	$90,016	$144,863
4.5%, Rebate of $10,499	21,698	87,427	153,993
5.5%, Rebate of $26,032	12, 733	91,647	171,587

 

At the risk of over-simplification, borrowers can be placed in one of four categories.

Cash-Short, Time Horizon Short: Borrowers in this category would unambiguously benefit from a high rate/rebate combination. They need the cash to meet all the settlement charges, and because they do not expect to have the mortgage very long, they won’t pay the higher interest rate, which is the quid pro quo for the rebate, for very long.

But don’t draw more cash than you need, it cannot be put in your pocket or used to increase the down payment.. And while a rebate can be used to meet the escrow requirements at closing, it cannot be used to place excess funds in the escrow account in anticipation of future tax increases.  Any excess rebate must be left on the table.

Income-Short, Time Horizon Long: Borrowers in this category would unambiguously benefit from a low rate/high points combination.  The lower rate reduces their monthly payment, and because they expect to have the lower rate for a long period, they earn a high rate of return on the points that are the quid pro quo for the low rate.

Cash-Short, Time Horizon Long: Borrowers in this category are conflicted. They need the rebate to meet cash needs, but they would pay the higher interest rate, which is the quid pro quo for the rebate, for a long time.  The borrower must make a painful tradeoff, taking the smallest rebate that is workable, perhaps zero points.

Income-Short, Time Horizon Short: Borrowers in this category are also conflicted. They need the low rate to reduce the mortgage payment but the cost is high because the low rate does not last very long. The borrower must make a painful tradeoff, taking the highest rate that is workable, perhaps the rate at zero points.

Who Makes the Call? Borrowers frequently don't choose the combination that is best for them for the same reasons that they often don't select the best type of mortgage: their own ignorance, inadequate disclosures, and poor guidance by their loan provider -- loan officer or mortgage broker, henceforth LP. If a borrower doesn't understand that there is a choice to be made, the LP may steer him toward the rate that carries zero points because it requires the least time and effort by the LP. That may or may not be the best choice for the borrower.

Borrowers who want to make this call for themselves need easy access to data on total mortgage cost over any time period. As far as I know, my site is the only available source of such data.