Mortgage Financing Tips – Pay Points Or Don’t Pay Points?

Mortgage Financing Tips – Pay Points Or Don’t Pay Points?

Here’s How To Know When and If You Should Pay Points

Making the wrong decisions with your mortgage financing could end up costing you thousands of dollars in unnecessary interest or fees. So taking some time to understand the nuances of different loan terms including rates and points can consequence in meaningful savings to you over the life of your loan.

There are two types of “points” that your lender may refer to when discussing a loan program’s rates and fees. One kind of point is a “discount point” and the other kind of point is an “origination point”. These two types of points serve two thoroughly different purposes, but they are similar in one respect: in both situations a point is equal to one percent of the loan amount. We’re going to focus on discount points in this discussion but it is important that you understand the distinction between these two types of “points”.

An origination point is a fee charged by the lender to originate the loan (which includes taking the application, collecting the required supporting documentation, processing the loan, etc) and is part of where the lender earns his profit on the loan (the lender earns profit by additional method but that is beyond the scope of this report). You should always try to negotiate the lowest possible loan origination points.

A discount point is essentially the present value of the interest that would be earned over time by the lender. This is a little confusing but in simple terms you can reduce the interest rate on your loan by paying the lender discount points upfront. Discount points are generally non-negotiable relative to a specific interest rate. The following example may help with your understanding.

The More You Understand About Discount Points the Better

Hopefully the following example will help you quickly determine the best discount points-to-interest rate for you, how many points should you pay, and what formula is best for you.

If a lender is giving you several options of interest rates and discount points, you need to calculate and analyze the financial consequences of each so that you can ultimately structure the “lowest total cost” mortgage for yourself. For our example let’s assume that you were considering two loans. Both are for $250,000, and both are amortized over 30 years with fixed rates. Remember that one discount point equals 1% of the loan amount:

Option #1: One loan that your lender offers you is 5.5% with 0 discount points ($250,000 X 0.0% = $0.00).

Option #2: The other loan that your lender offers you is 5.0%, but at a cost of 2 discount points ($250,000 X 2.0% = $5,000).

The dominant factor that will determine which loan option is better for you (with the lowest total cost) is how long you expect to keep the loan. So, the first thing you need to think about is how long you’re going to live in that home. The average homeowner spends between 5.5 and 7 years in their home before selling for in any case reason.

So, for example sake, let’s say you plan to live in the home five years. Here’s how you determine which loan option is better because it will consequence in the lowest total cost over 5 years.

Here’s how we calculate that. First of all you need to calculate the loan payment (principal and interest only) for the loans. For a $250,000 loan at 5.5% interest the monthly payment is $1,418.29, and for the same loan amount at 5.0% the monthly payment is $1,340.75.

1. Multiply each payment times 12 (months)

$1,418.29 X 12 = $17,019 (total loan cost/year)

$1,340.75 X 12 = $16,089 (total loan cost/year)

2. Subtract the lesser from the greater

$17,019 – $16,089 = $930 (total payment difference between 5.0% loan and 5.5% loan)

3. DIVIDE that amount into the $$ cost of the points you would pay to determine the number of years it would cost to retrieve the points paid up front.

$5,000 (cost of points 2.0% X $250,000) / $930 = 5.38 years

In this example if you stay in your home for only five years, you will NOT recoup the additional cost of the discount points you paid up front with the lower payment provided by a lower interest rate. The break-already point in this example is about 5 years and 5 months. So your best bet would be to select loan option #1.

If, however, you planned to keep your home beyond 5 years and 5 months, you’d be better off with loan option #2 (the longer term savings in interest rate will go beyond the amount you paid in points – not considering the time value of money).

So, in summary, if, after using this formula you determine that the number of years that it takes to recoup, or break already, is LESS than your expected time in your home, you’ll be better off paying the points and getting the lower rate. If the number of years that it takes to recoup, or break already, is higher than you plan to use in the home, you are better off choosing the higher interest rate and not paying the up-front discount points.

I hope this helps you to see how important it is to understand the important details of your home’s financing, and how important it is to shop for the best rates, terms, and points. If you are fortunate enough to be working with an honest and ethical lender he or she will take the time to explain and show you how to select the best and lowest overall cost mortgage loan for you.

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