How do lenders make money up front on your mortgage?

Key Takeaways

Lenders make money upfront on mortgages through origination fees, which are typically a percentage of the loan amount.
They may also charge discount points, where each point represents 1 percent of the loan amount and is paid upfront to lower the interest rate.
Additionally, lenders may earn revenue through servicing fees, which are paid by borrowers for the ongoing management of the loan.

Lenders make money on your mortgage loan by charging you an origination fee, among other fees. An origination fee is a percentage of the total loan (usually half a percent to one percent) that you pay up front when getting the loan [source: Investopedia]. Lenders don't do this just to ensure they're getting some money off your loan up front, but because it quietly increases the interest rate you're paying over the entire loan.

For example, if you take a $100,000 loan at seven percent that has a three percent origination fee, you pay the origination fee (and all other applicable fees, such as processing fees, closing fees, etc.) at the time you take the loan. Your monthly payment is calculated as seven percent of the total loan amount (the $100,000), which translates to a $665.30 payment per month. However, once you've paid the origination fee (and other fees), you're now paying a $665.30 monthly payment on a lower total balance. Say the origination and other fees on this loan total $3,820 ($3,000 on origination alone). Your loan balance is now $96,180, but you're still paying $665.30 a month. That means you're really paying an annual percentage rate of 7.39 percent. So the result of the origination fee and other up-front fees is that you're paying more in interest over the life of the loan than you might think you are. Interest is where the lenders make their money; it's why they're willing to lend you money in the first place.

Do note that the larger the loan, the less the impact these fees will have on your overall interest rate. Also remember that the higher the up-front costs on your loan, the higher your effective interest rate will be if you pay the loan off early.

Frequently Asked Questions

Are there ways to reduce the upfront costs of a mortgage?

Yes, negotiating with the lender to waive or reduce origination fees or discount points can lower upfront expenses. Additionally, exploring government-backed loan programs or seeking out lenders that offer promotions or incentives may help minimize upfront costs.

Can I roll upfront mortgage costs into the loan amount?

Rolling upfront mortgage costs into the loan amount, known as financing closing costs, is possible in some cases. However, this increases the overall loan balance and may result in higher monthly payments and interest costs over time. It's important to weigh the pros and cons and consult with a financial advisor to determine if financing closing costs align with your long-term financial goals.