Which Mortgage Should I Take?

John and Betty are very lucky. They are 30 years old; they just got married; and they have reliable jobs in today’s economy--earning $50,000 each. The couple has a 3 year-old and a 1 year-old. They plan to send their children to moderately expensive colleges and to retire at 65. They have a $12,500 in savings, plus $70,000 set aside for a down payment on a house.

Today, John and Betty are celebrating. They just made a $350,000 offer on a house they love, and it was accepted! So now they need a mortgage. But, which one? They checked with Citigroup and found 19 different mortgages to choose among. The mortgages differed in three dimensions--the interest rate, the number of points, and the closing costs.

Paying points requires handing Citigroup an up-front fee equal to the number of points times the $280,000 mortgage ($350,000 less the $70,000 down) divided by 100. So paying, say, 3.75 points is just like paying an additional closing cost equal to 3.75 percent of the amount borrowed except for one thing--the outlay on points is tax-deductible.

To secure the lowest interest rate available--4.25 percent--John and Betty need to pay 3.75 points or $10,500 plus $2,974 in additional closing costs. Call this mortgage A. At the other extreme, John ad Betty can choose mortgage B, which has a 6.50 percent interest rate, but zero points and only $524 in additional closing costs. The APR (average percentage rate) for the 4.25 percent mortgage is 4.63 percent; it’s 6.56 percent for the 6.50 percent mortgage. The APR takes into account the points and closing costs and helps one compare different mortgages.

John and Betty like the sound of a 4.63 percent average percentage interest rate compared with a 6.50 percent APR, but they don’t like the sound of paying $13,474 up front (.0375 times the $280,000 mortgage plus $13,474) compared with paying just $524 up front. Moreover, John and Betty aren’t sure if comparing APRs is valid. They know that each mortgage comes with different tax breaks (deductibility of points and interest) over time.

What John and Betty really want to compare is not APRs, but the living standards they’ll enjoy if they take mortgage A rather than mortgage B. To do this, they simply set up and run two profiles in ESPlanner, one that assumes they choose mortgage A and one that assumes they choose mortgage B. In setting up these profiles, John and Betty enter points and closing costs as deductible and non-deductible special expenditures. Since they don’t expect to move in the future, they enter no future changes in their home.

It takes a matter of seconds for John and Betty to run ESPlanner and to see that their annual living standard (discretionary spending per person adjusted for economies in shared living and measured in today’s dollars) is $22,942 with mortgage A (low rate, high costs) and $22,505 with mortgage B (high rate, low costs). The difference between these living standards is 2 percent!.

This is a huge difference. It means 2 percent more discretionary spending for John and Betty every year for the rest of their lives.

Can John and Betty do better with one of the other mortgage choices? No, the other 17 options entail living standards between $22,505 and $22,942.

But before choosing mortgage A, John and Betty start worrying about moving. They consider how they’d fare were they to move in 5 years and have to take out a new mortgage. The answer is not much worse. If they take mortgage A (low rate, high costs) now and again starting in five years with a new mortgage equal to the remaining balance on the initial mortgage (i.e., they use the money--equity--derived from the sale of the first home as a down payment for the second), their living standard is $22,820. This is less than $22,942, but still higher than $22,505.

The bottom line--paying for a lower mortgage rate can raise your living standard!