Buyers ask: To pay points or no points?
September 30, 2016
Should a borrower pay points to get a lower interest rate? That is a good question, and it certainly seems to be back on the table as far as how to structure a mortgage transaction in the current environment with interest rates being so volatile.
For starters, let's understand exactly what "paying a point" means and how such terms are structured. Paying a point, or a 1 percent fee, at closing in addition to the other costs of the loan can be done as a means of lowering the interest rate. One percent of the loan amount is then added in to the total closing costs of a mortgage due at closing. For simplicity's sake, let's look at 1 percent paid up front as opposed to paying more than or less than a 1 percent fee. Generally speaking, 1 percent of the loan amount paid at closing will reduce the interest rate for the loan between .25 percent and .375 percent. Easy enough, right? A fee is paid to reduce the interest rate.
Determining whether or not this is financially advisable is where the scenario gets a little more complex. How much the fee is will be dependent upon how big the loan amount is. Thus, it must be determined if the borrower has the money accessible to pay for the fee. Paying points can be applied to both a purchase and a refinance transaction. Borrowers have successfully negotiated for this fee to be paid by a seller in many purchase transactions, but that is a topic for another column. In the case of a refinance, existing equity in the property may be used to roll the fee into the loan amount or pay for the fee if applicable.
Assuming the borrower either has enough equity or liquid funds to cover the fee, mathematics come into play to determine the advisability of paying the fee. A break-even calculation is set up to see the actual numbers. For example, a $300,000 loan would have 1 percent origination fee of $3,000. The rate on a 30-year fixed rate mortgage may be reduced from, say, 3.5 percent to 3.25 percent.
The monthly mortgage payment on $300,000 at a rate of 3.5 percent is $1,347.13. At a rate of 3.25 percent, the payment is reduced by $41.51, to $1305.62. Therefore, the break-even on paying the fee, or the number of months it will take for the monthly savings to add up and cover the fee, is 72.2 months. However, it is also important to look at the interest saved over the life of the loan, or the 30-year term in this case. Total interest due over the life of the $300,000 loan at 3.5 percent is $184,969. That figure is reduced by $14,947 at a rate of 3.25 percent.
Every scenario is different as to whether or not buying down an interest rate is advisable. If a borrower has anticipated plans of paying down a mortgage with additional principal reduction payments over the course of the loan, having a lower interest rate may have much more of an impact. Mortgages with less than a 30-year term typically have more significant savings with a lesser rate making such scenarios particularly worthy of examination.
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In an environment with rising interest rates that we will likely see as we move forward, all options need to be fully examined as to the best financial course of action for the borrower. As always, the best way to do so is with the assistance of a seasoned mortgage professional.
William A. DesPortes of Central Rockies Mortgage Corp. can be reached at 970-845-7000, extension 103, and firstname.lastname@example.org.
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