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Understanding mortgage rates and points can help you step into home ownership with a payment option tailored to fit you.
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Watching mortgage rates can feel like a game: rates rise, rates fall, rise, fall. As homebuyers and homeowners, our job is to analyze the market, make a prediction, and lock in. There’s a second level to mortgage rates, however, which involves the fees charged to obtain the loan, or the mortgage points charged on the loan.
Points are fees paid to obtain a home mortgage. Each point is one percentage point of the total loan amount. Thus, one point (one percent) of a $100,000 loan is $1,000. The word “points” is often used in two ways: for loan origination points and discount points.
Loan Origination Points
Loan origination points are fees lenders charge to start the loan process. The points or even fractions of points often differ among lenders. Some don’t charge any. Comparison shopping is important.
Discount Points
Discount points are another fee altogether. Here again, one point equals one percent of the total loan amount. The numbers of points charged varies by place, time, and lender and with the mortgage and investment climate.
More points may be charged if a borrower has credit problems and is a risk. In that case, lenders also may require a higher mortgage rate than advertised. Those with shaky credit may find they have to pay two, three, or four times as many points as others with good credit. That’s why keeping a good credit history and comparing all the costs of a mortgage are so important.
Points also can be “bought.” Home buyers with cash on hand who plan to stay for some time in the house they are purchasing may decide to “buy down” points to get a better interest rate. While they will have to bring more money to closing, they will enjoy lower monthly payments over the life of the loan.
A rule of thumb is that for each point prepaid, the mortgage rate drops about one-quarter (.25) of a percent. It is not a one percent for one percent deal! In addition, lenders usually cap the number of points that can be prepaid.
When to Buy Down Points
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Buying points may make your mortgage easier to handle, but paying them up front might get you into the home you love faster.
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When does it make sense to prepay points? It depends. If the needed is cash on hand, there may be a better way to invest it. Do some calculating before you decide. Divide the total cost of the points by the savings in each monthly payment. That answer is the number of payments it takes to break even. If the number of months to payback is longer than you plan to have the mortgage, another loan option should be considered.
Let’s look at a $100,000 loan amortized over 15 years. Buying down one point would bring the mortgage rate from 6.00 percent to 5.75 percent. One point would cost $1,000 (one percent of the $100,000 loan) up front at closing. At 5.75 percent, the monthly payment would be $830.41. At 6.00 percent, the monthly payment would be $843.86. Divide the total cost of the prepaid point ($1,000) by the savings in each monthly payment ($843.86 - $830.41 = $13.45) and the answer is 74.34. That’s the number of monthly payments to be made before any benefit is realized. Homebuyers who plan to stay in their house for more than 74.34 months (about six years and two months) would reap the benefits. Those who don’t plan to live there that long would want to seek another loan option.
Those without cash on hand who think of borrowing to prepay points should think again. To do so will increase the loan amount and total costs because the borrower will be paying interest on that for the life of the loan.
Look at the Whole Picture
The Truth in Lending Disclosure Statement shows the Annual Percentage Rate (APR) and other payment information for the loan. Consumers should ask lenders for the APR before applying to compare loans.
The Real Estate Settlement Procedures Act requires lenders to give borrowers an information booklet about settlement services and a good faith estimate of settlement costs within three days of receiving a written loan application. It also requires that at closing or shortly after a borrower must receive a settlement statement, which is a permanent record of all the final settlement charges. A borrower is entitled to review the settlement statement one business day before closing on the loan.
If a lender is not advertising the buy down option, it may be worthwhile to ask. In addition, those who must relocate for jobs might want to check regarding company benefits. Some companies pay closing costs and up to one point when employees must relocate and purchase a home.
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When Paying Down Points Makes Sense
Dan and Rebecca, newlyweds in their 20s, have found their perfect forever home. It’s close to jobs, friends and family, is located in their favorite neighborhood, and has a mortgage that works for them at $180,000. They have $3,600 on hand to buy down two points, which would take the rate from 5.50 percent to 5.00 percent on their 20-year loan. At 5.50 percent, the monthly payment would be $1,238.20. At 5.00 percent, it would be a more comfortable $1,187.92. The savings of $50.28 would pay back the $3,600 paydown in about six years. Since they plan to stay there for many years, they go for it.
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Think Before You Pay Down Points
Thirty-somethings Will and Lara have decided to stop paying rent and start building equity in a property of their own. They’ve found a great older house with a lot of possibilities for a 15-year fixed-rate mortgage of $140,000. They plan to put $2,800 in savings and their design and carpentry talents into the fix-up. They skip the opportunity to buy down two points and decrease the rate by half a percentage point because the difference in monthly payments would only be $36.81. It would take about 6.3 years before they would start seeing a savings if they opted for 5.00 percent instead of 5.50 percent. They decide that the appreciation in value would benefit them more than a buydown ahould they decide to sell in a few years.
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