A guide to origination fees
As you shop for the best loan deal, you may find lenders that charge an origination fee to fund your loan. Those fees could, understandably, cause some hesitation. But comparing fees and interest rates from different lenders will help you choose a loan that minimizes your borrowing costs — which means it might make sense to pay an origination fee.
How Origination Fees Work
An origination fee is an upfront charge that you pay to a lender for funding your loan. The fee compensates your lender for their marketing, underwriting, and loan processing costs.
No loan, no fee
You only pay origination fees if the lender approves your application and you accept their offer.
How you pay
You may be able to pay an origination fee in several ways, and the details vary from lender to lender. Some lenders add the fee to your loan balance, some take it from your loan proceeds, and others allow you to pay out of pocket.
Pay a percentage
Lenders typically quote origination fees as a percentage. For example, a loan might require a 2 percent origination fee, so you'd pay $20 for every $1,000 you borrow.
What you're paying for
Origination fees help lenders cover the cost of funding your loan. For example, they need to:
Compensate people for marketing, helping you apply, and organizing required documentation
Review your credit (or use other methods to determine your creditworthiness)
Verify your identity and the details of your loan
Research any collateral and other aspects of your loan
Other potential fees
Some lenders charge additional fees (besides interest and origination fees), while others simply cover their costs through a single origination fee. Potential fees you might pay include:
Application fees
Credit report fees
Appraisal fees
Title search
And more
Should you pay an origination fee?
Origination fees traditionally paid mortgage brokers for arranging loans, but they've evolved to cover a broad range of services required to fund loans. It's wise to evaluate the pros and cons of these fees and how they affect your loan
Paying an origination fee may enable you to qualify for the lowest rates available
What about “no closing cost" loans?
Some lenders market loans with no closing costs. With those products, you might avoid paying origination fees, but you still pay, and you might pay more than you think. Loans with no closing costs usually have a higher interest rate than loans that use origination fees. Instead of paying up front, you pay more over time — possibly for many years
Breakeven analysis
A breakeven calculation can help you determine whether or not you would benefit from paying upfront fees. To understand your breakeven point:
Note exactly how much you must pay up front.
Determine the effect on your loan — a lower monthly payment and reduced interest costs, for example.
Find the monthly payment and interest rate for a loan with no closing costs (which typically has a higher monthly payment).
Calculate the difference between the two monthly payments. How much more do you pay monthly if you choose not to pay an origination fee?
Divide the monthly difference into the origination fee. The result is the number of months it takes to recoup the origination fee.
If you plan to keep your loan long enough to pass the breakeven point, it may make sense to pay an origination fee. What's more, the lower interest rate you secure with an origination fee means you should pay less interest over the long term.
An Example
Some details may help model the process of evaluating origination fees.
Assume you can borrow $50,000 with an origination fee of 3 percent and an interest rate of 4.99 percent. The origination fee is $1,500, (resulting in a loan balance of $51,500) and you repay the loan over ten years. Your monthly payment is $545.99, and you pay $14,018.29 in interest over the life of the loan. You also pay off the extra $1,500 in your loan balance, for a grand total of $15,518.29
By comparison, you might find a $50,000 with no origination fee. But that loan could have an interest rate of 6.5 percent, resulting in a monthly payment of $567.74. That may seem like a small difference, but this loan has $18,128 in total interest costs over the same ten years.
For a quick breakeven analysis:
The difference between the two monthly payments is $21.75 per month.
$21.75 divided into $1,500 has a breakeven period of roughly 69 months.
If you plan to pay off the loan before 69 months, the conventional wisdom says to take the loan with no origination fee. If you pay for longer than the breakeven period, it may make sense to pay the upfront fee and secure a lower rate.
When to choose (or avoid) origination fees
A detailed analysis is the best way to decide which route to take. But some guidelines may help to solidify the concepts in your mind.
In general, it makes sense to pay an origination fee whenever you come out ahead. You always pay to borrow — the question is when you pay, how much, and whether or not you can clearly see the costs.
Gradual debt reduction
If you have a significant debt that you want to pay off over several years, it may make sense to pay an origination fee. Doing so minimizes your interest costs and makes cash flow easier during those years. There's nothing wrong with taking a few years to pay down debt, as long as you have a plan and stick to it.
Rapid debt elimination
If you have a significant amount of extra cash flow every month, and you plan to pay off your debt within the next year or two, it might not make sense to pay an origination fee. If you're only going to pay interest for one or two years, you need a significantly lower rate to benefit from an origination fee, and that upfront charge could go toward your loan balance instead.
Determine how rapidly you can realistically pay off debt, and compare the all-in cost of several different loans. With that information, you can choose the option that works best for you.
