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Understanding Mortgage Points: Rate vs Fee

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Understanding Mortgage Points: Rate vs Fees

What are Points?

No single issue confuses borrowers more than “points.” Points are an upfront fee that is paid to lower your mortgage interest rate. One point is 1 percent of the loan amount. On a $200,000 loan, 1 point would be $2,000 and 1.5 points would be $3,000.

Why is it Important to Understand Points?

Many borrowers mistakenly believe that some lenders charge points and other lenders don’t. Some also believe that when they pay no points, they are getting something for free. Not true. Virtually all lenders offer about a dozen rate-versus-fee alternatives on every loan. They may not tell you about them all, but these alternatives always exist. Here is a small portion of a typical rate sheet:

Rate(%) Points
6 zero
5.875 .5
5.75 1
5.625 1.375
5.5 2

Most loan representatives expect that you won’t want to pay points, so they only tell you about one option – the rate with no points. Unless you ask for other pricing alternatives, the no-point option is the one you’ll be stuck with. Even if you ask, the loan officer may offer just one other alternative, like paying one point, but there are five here and another seven not shown. If you are going to make a decision, you want to know all of the options. There is no reason why your loan representative can’t give you a printout of information that is right on his desk or computer screen. If he refuses to give you the information you need, get up, walk out, and find a more cooperative lender, or ask to speak to the boss. Be firm in your resolve to get this information.

More people would consider paying points if they knew the benefits. It’s important that you learn about them now so you will be prepared when you have to lock in your interest rate and it’s time to decide whether or not to buy points.

How do I Decide if I Should Pay Points?

Start out assuming that you will pay no points unless you find that it is to your advantage to do so. The trick is to find out how quickly you get your money back. Here’s that same rate sheet again with one more column – the breakeven period. The breakeven period is the length of time it would take to get your money back if you paid points.

Rate(%) Points Breakeven Period
6 zero
5.875 .5 4 years
5.75 1 4 years
5.625 1.375 3 years
5.5 2 5 years

Note: The values in the chart serve only as an example to describe the concept and do not reflect the rates and points you should expect from your lender. Rates and points fluctuate as market conditions change over time.Look at the first two alternatives in the chart. You can see that the rate is one-eighth of a percent lower (6 – 5.875 = .125 = 1/8) for each one-half point you pay up front. If you pay one full point, you get a rate that’s one-quarter percent lower. That may not sound like much, but on a $100,000 loan, the one-quarter percent reduces the annual interest cost by $250. To buy that one point you pay $1,000. That’s equivalent to a 25% annual return-on-investment ($250/$1,000). Leave that $1,000 in the bank and what interest do you get? Not much. Note that with that $250 reduction in interest, it will take only four years to get your $1,000 back, a four-year breakeven period.

The good news is that you continue to save that $250 every year. The savings over 10 years amounts to over $3,000! If you were to keep the loan for its full term, it adds up to over $14,000, all from that $1,000 investment. And of course, your loan will be more than $100,000 so your savings will be even greater.

Going back to the chart, you can see that the next buy down only costs another .375 points for the next one-eighth rate reduction. That’s a three-year breakeven, which is terrific. The next one after that is a five-year breakeven. The question is: “How long are you going to be in the home?” If you plan to be there for longer than the breakeven period then you should pay points.

Ask your loan representative to make a little chart just like the one above so you know which alternative is best for you. If they won’t calculate the breakeven period for you, be sure to get the rate sheet so you can do it yourself, or with your loan representative’s help. Keep the rate sheet as you’ll want to refer to it and compare it with the rate sheet on the day that you lock in your rate.

Finally, some lenders or brokers might simplify the calculation for you in the following manner: “On your $200,000 loan, 1.5 points cost $3,000 and reduce your monthly payment by $33. Divide 3,000 by 33 and you get 91 months, or 7.6 years, that you have to wait to break even.”

This is just a rough estimate. The calculation is not that simple. An accurate breakeven calculation must include points, monthly payments, the interest earnings on both the points and the monthly payments using the borrower’s investment rate, tax savings and the reduction in the loan balance.

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