SANTA CRUZ (January 20, 2008) - Some banks and mortgage companies like to advertise that their loans have low or no closing costs and will disguise how the borrower will pay for the costs that a new loan requires. There are also those lenders that lay it out on the table at the beginning of the process. The fact is that it costs money to originate a loan to buy or refinance a home because each transaction requires dozens of professional and clerical workers spending dozens of hours, having an untold number of conversations, creating and checking hundreds of typed pages of instructions and documents.

It is the borrower who must ultimately pay these costs because it is the borrower who benefits. When it comes to paying closing costs, the borrower has choices. Put simply, it is pay now or pay later. The best choice for the borrower is primarily dependent on how long the loan will stay in place. That is, when will the borrower pay off this loan? It will be paid off when either the home is sold or when the loan is refinanced and replaced with another loan.

The one-time fees associated with obtaining a mortgage are called non-recurring closing costs. The typical title, escrow and lender fees on a loan of $400,000 are between $3,000 and $4,000 plus the loan origination fee, or points. One point is one percent of the loan amount and will vary between zero and 2 points. With the addition of one point, the non-recurring closing costs would add up to between $7,000 and $8,000.

When compared to the closing costs that a seller will be paying, somewhere between $20,000  and $40,000, when selling a home priced at $600,000, buyers’ closing costs seem like a bargain! While a home seller could attempt selling his home himself to save money, I believe that the expertise of a knowledgeable and professional real estate agent will prove to be a wise investment.

The borrower also has recurring closing costs to pay at the close of escrow. Prepaid interest, 12 months of homeowner’s insurance and property taxes are called recurring closing costs and can be as much or more than the non-recurring closing costs.

The good news about points is that the more points the borrower pays, the lower the interest rate will be. In addition, points become a deductible expense on the borrower’s tax returns when purchasing a home that the borrower will be living in. The IRS considers these points the same as prepaid interest.

Banks as well as mortgage companies use the loan origination fee to pay the mortgage originator (yes, banks pay their originators a commission too) and to pay for a portion of the services. The lender is willing to reduce or eliminate the loan origination fee in return for the borrower paying a higher-than-market interest rate. The higher interest rate means that the borrower will be making higher payments for the life of the loan.

For example, on a $400,000 mortgage, the 30 year fixed rate was, amazingly, on the order of 5.50 percent last week, which required a loan origination fee of one point, or $4,000, and a payment of $2271 per month. For no points, the borrower would receive a rate of 5.75 percent, “save” $4,000 in closing costs and would have to pay $2334 per month, $63 more. Over the life of the loan, the higher interest rate would cost the borrower $22,680 in additional interest.

However, if the borrower is only going to keep the loan for a short period, he or she would be better off to pay no points. The “break-even” point in this example happens at 63 months. If the borrower plans on keeping the loan longer than 63 months, there is an advantage to paying the points.

Lenders may use this same technique to reduce or minimize the other non-recurring closing costs. If the borrower accepted a rate of 6.00 percent, the lender would be willing to waive the points and will pay the other non-recurring fees, including title and escrow fees. Be aware that some lenders charge a 3 to 5 year prepayment penalty to discourage a borrower from paying off their mortgage early. This penalty can be as much or more than the closing costs would have been.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 or email him at Peter@SantaCruzHomeFinance.com.