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Understanding Mortgage Points: Rate vs Fee

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Understanding Mortgage Points: Rate vs Fees

Mortgage rates have been at or near record lows for a few years now, but as rates rise in the future, you might find yourself yearning for those super-low post-recession rates that some lucky homebuyers with solid jobs and good down payments got their hands on. After all, who wouldn’t want a lower mortgage rate?  

There’s an easy way to get a lower interest rate on your mortgage — pay some points. Here’s everything you need to know.

What Are Points on a Mortgage Loan?

Put simply, points are an upfront fee that is paid to lower your mortgage interest rate. One point is equivalent to 1% of the loan amount. So on a $200,000 loan, for example, one point would equal $2,000. Discount points refer to prepaid interest, as purchasing one point can lower the interest rate on your mortgage by 0.25%. Origination points, which are used to compensate loan officers, aren’t as common and can be negotiated. For the purposes of this article, we’ll focus on discount points, known as points on a mortgage.

Why Is it Important to Understand Points?

Many borrowers mistakenly believe some lenders charge points and other lenders don’t. Some also believe that when they pay no points, they are getting something for free, but that’s not true. Virtually all lenders offer about a dozen rate vs. fee alternatives on every loan. They may not tell you about them all, but these alternatives always exist.

Here is a sample rate sheet. (Note: This is not a definitive metric, and we recommend checking with your lender for an up-to-date version of their own mortgage rate sheet).

Rate(%) Points

  • 6 zero
  • 5.875 .5
  • 5.75 1
  • 5.625 1.375
  • 5.5 2

Some loan representatives expect you won’t want to pay points, so they only tell you 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.

There is no reason why your loan representative can’t give you a printout of information that is right on their desk or computer screen. If they refuse to give you the information you need, find a more cooperative lender or ask to speak to the boss. Be firm in your resolve.

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 You Calculate Points on a Mortgage?

Start out by assuming that you won’t pay points unless you find it is to your advantage. The trick is to find out how quickly you’ll get your money back.

Here’s that sample rate sheet again with one more column, the break-even period. The break-even period is the length of time it would take to get your money back if you paid points.

Rate(%) Points Break-Even 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 upfront. 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 will 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 break-even period.

The good news is that you’ll continue to save that $250 every year once you break even. If you plan on staying in your home for 10 years, for example, your savings top $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 likely 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 break-even, 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 break-even 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 break-even 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 break-even 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.

Remember, taking out a mortgage can have a significant effect on your credit, so it’s a good idea to review your free credit scores on before you apply.

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