Mortgage lenders definitely have a language of their own. Whether buying a new home or refinancing an existing mortgage, the average borrower can be very intimidated if their loan counselor is not a good communicator. One of the most confusing (and potentially expensive) aspects of a mortgage seems to be the concept of paying points for a rate.
What is a Mortgage Point?
Officially called a discount point, one point equals 1% of the amount borrowed. If borrowing $100,000, one point equals $1,000, 1/2 point equals $500. Since points are paid in addition to closing costs (appraisal, title insurance, etc.) points increase upfront costs. The origination fee is never more than 1% and is similar to a point.
Why Pay Mortgage Points? You're Buying Down the Rate!
Paying points lowers the interest rate which, in turn, lowers the monthly payment. This is called buying down the rate. To pay or not to pay points depends on the situation. How long will the borrower live in the home? How much cash is available? What’s most important to the borrower, lower payment or lower closing costs?
The Rate and Point Connection
All lenders offer different rate/point options that change daily. Every rate has a correlating point value, even if it’s zero. The quote sounds like this: 6% comes with 1% origination fee and .50 discount points. It’s sometimes possible to get a rate with no origination fee and zero discount points. The rule of thumb is the higher the rate, the lower the points, and vice versa.
How Do Points Affect Payment and Costs?
Example: $100,000 30-year fixed rate mortgage with estimated closing costs of $3,000.
Option A
5.5% Rate
1% orig. fee $1,000
1.25% Points $1,250
Closing Costs $3,000
Total due at closing $5,250
Monthly Payment* $567.79
Option B
6.0% Rate
1% orig. fee $1,000
.50% Points $ 500
Closing Costs $3.000
Total due at closing $4,500
Monthly Payment* $599.55
Option C
7.0% Rate
0% orig. fee $ 0
0% Points $ 0
Closing Costs $3,000
Total due at closing $3,000
Monthly Payment $665.30
* Principal and Interest (taxes and insurance not included)
Analyze the Point Options Even without a Mortgage Calculator
There are many good mortgage calculators on the web to help analyze options, but simple math can be applied as well. As illustrated above, Option A’s total costs are $2,250 more than option C, and the payment $97.51 lower. To determine the best option, divide the extra cost by the payment savings which determines a breakeven point. In this scenario, it is 23 months. Therefore, if plans are to own the home for at least 23 months, the additional costs paid at closing (points) for the lower rate will be recouped.
Home Purchase: What if the Seller is Paying Toward Closing Costs?
In a purchase situation, often a seller or home builder is willing to pay all or part of the closing costs. If the seller agrees to pay $5,000 of the closing costs, it makes sense to use every penny of that, and select the rate/point Option A, paying $250 out of pocket, rather than Option C which leaves $2,000 on the table. After all, regardless of the borrower's situation, if the seller is paying the points, who cares how long it takes to recoup that additional cost?
Tax Bonus
Points are not a bad thing; they simply provide options. AND, remember those points are considered a form of pre-paid interest and are tax deductible in the year they are paid!
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