what is points on a mortgage
Mortgage is a generic term used to describe several different combinations of legal documents that allow you to get financing to buy a home. The documents (note, bond, mortgage, deed of trust, open-end-mortgage, security deed, and riders) that you use depend on the state in which the property is located and the type of loan you are getting. (See Appendix K for a list of what system each state uses.)
A mortgage is a financial claim against your real estate. You give a mortgage to a lending institution, along with a bond or a note, which is a personal promise to repay In return, the lender gives you money – cash. You are the mortgagor The lender is the mortgagee.
A document called a deed of trust secures loans on properties located in deed of trust states. When you sign a deed of trust, you actually transfer ownership of the property to a trustee. Until such time that the loan is paid off, the trustee holds the deed to the property in trust. If a dispute arises between lender and borrower, the trustee must resolve the dispute according to state law. If the borrower stops making loan payments, the trustee must hold a foreclosure sale to pay off the lender. The deed of trust and state law clearly spells out the procedure for a foreclosure, and in most states, a court hearing is not required. In most mortgage states, however, the lender must go to court, argue the case before a judge, and obtain the judge's approval before holding a foreclosure sale. Lenders prefer to have loans secured by deeds of trust because foreclosing on a deed of trust is cheaper and quicker than on a mortgage. As a borrower, you can consider mortgages and deeds of trust as generally interchangeable terms in this book.
Question: Which is a better deal: (1) a 30-year fixed-rate mortgage at 8 percent interest plus three points or (2) a 30-year fixed- rate mortgage at 8.25 percent interest plus only one point?
Comparing prices of different mortgages is complicated. In addition to the quoted interest rate, lenders charge a variety of additional up-front fees:
• Appraisal and credit report fee
• Inspection fee (for new homes)
• Document preparation fee
Discount points, often referred to simply as points, are usually the largest fee that lenders charge. Each point equals 1 percent of your loan amount. If you borrow $200,000 but have to pay three points, you really get only $194,000. However, you have to repay $200,000, and you have to pay interest on $200,000.
Points change the interest rate that you pay. The real rate is the effective interest rate. For a 30-year loan at 8 percent plus the three points repaid over its full 30-year term, the effective interest rate is 8.32 percent.
The annual percentage rate (APR) is the effective interest rate for loans that are repaid over their full term. After you apply for a loan, truth-in-lending laws require lenders to tell you a loan's APR within three business days. While this is better than not knowing what rate you are paying, there are two problems with this procedure:
1. Finding out the APR after you apply does not help you with comparison shopping.
2. The APR calculation assumes that you will keep your loan for its full 30-year (or 15-year) term. However, most people sell or refinance their home within 6 to 12 years.
The effective interest rate depends on how long you keep your loan. If the $200,000 loan were repaid after six years rather than 30 years, its effective interest rate would be 8.66 percent, not the 8.32 percent APR.
You need a computer or financial function calculator to determine effective interest rates precisely, but the following formula is a fairly accurate way of estimating it for comparison shopping:
Effective interest rate = Quoted rate + (Number of points ÷ 6)
(If you know that you will be keeping your loan for more than 12 years, divide the points by 8 instead of 6. If you plan to stay for only four to six years, divide the points by 4. If you plan to stay for one to three years, divide the points by the number of years.)
Let's go back to the question posed at the beginning of this section: “Which is better, (1) a 30-year fixed-rate loan at 8 percent plus three points or (2) a 30-year fixed-rate loan at 8.25 percent plus one point?” Loan number 2 is better.
Loan 1: Effective rate = 8% + (3 points -r 6) = 8.50%
Loan 2: Effective rate = 8.25% + (1 point -r 6) = 8.42%
That small percentage difference does not seem like much, but for a $200,000 loan paid off after 12 years, you would save $2,000. If you paid off the loan after only six years, you would save $3,000. Shopping and knowing how to shop saves money!
Sometimes lenders charge a one point (or half-point) origination fee. This has the same effect as discount points. You should add an origination fee to the discount points before you calculate your effective rate.
For purposes of comparison shopping, you usually do not have to add the other miscellaneous fees (credit report and appraisal, inspection, etc.) into your rate calculations. Although they increase your effective interest rate somewhat, they are less significant than points, and most lenders charge about the same amount of miscellaneous fees as their nearby competitors.
How can I save on mortgage points? How are mortgage points calculated?
A mortgage point refers to interest paid up front and is equal to one percent of the amount of the mortgage. Thus, on a $100,000 mortgage loan, five points would equate to $5,000.
Paying points can lower the interest on a mortgage. Two points paid might bring the interest rate on a loan down about half of a percent. The difference between paying 6.75% on a thirty year $100,000 loan and paying 6.25% on the same loan is about $30 on the monthly payment and $12,000 over the life of the loan; obviously, the larger the loan amount the more savings on both the monthly payment and the total loan paid. If you can afford to pay points and plan to be in your home for a long time then paying points may be a good idea.
How do you know if you should consider paying points?
First, how much cash are you able and willing to put down? If you are short of cash, then paying points probably isn’t an option. Second, what is your income relative to your debt? If your debt load is high you may have to pay points. Paying points will give you a lower interest rate and a lower payment. Having a lower mortgage payment may bring your total debt to income ratio in line and make it easier to qualify for the mortgage you need.
Once you have decided if you are equipped to pay points and want to do so there are three final considerations: How long do you plan to be in your home? Do you think you may refinance your home in the next two to three years? How much would the money you are using to pay points earn for you if invested elsewhere?
It will take almost five years to recoup the cost of paying two points on a 30 year $100,000 loan financed at 6.25% versus a no points 30 year $100,000 loan financed at 6.75%. Two thousand dollars placed in a certificate of deposit earning 3.5% would yield a pre-tax return of more than $375 over five years. In this case, if you plan to stay in the house less than five years or to refinance it in less than five years, then think about choosing the higher interest rate and putting the $2,000 in a CD. However, if you have ample cash for your down payment and other closing costs and plan to stay in your home without refinancing for more than five years then paying a few points may be advisable.
How to Decide If Mortgage Points Are Worth the Cost
As you shop around for a mortgage, you want the lowest possible mortgage rate. A lower mortgage rate can mean a savings of tens of thousands of dollars on your home loan.
Eventually, though, you end up with the lowest rate available to you. What are your options then?
If you still want to see how low you can go, it’s possible to “buy” mortgage points in an effort to gain an edge.
When talking about saving money on mortgage interest, you might hear talk of “buying down the mortgage” or paying “discount points.” These are both mortgage terms that refer to the practice of paying for mortgage points.
If you buy mortgage points when you close on your home, you get a lower interest rate. The lender quotes you a rate, and then you can purchase a reduction in the interest in order to get an even lower rate.
One mortgage point is equal to one percent of your mortgage amount. So, if you get a mortgage for $200,000, one mortgage point is equal to $2,000.
Not only can you buy points to get a better interest rate on your home loan, but you might also get a tax deduction. The points you pay are considered part of your mortgage interest, so consult with your tax professional to see if you can deduct points to get even more value out of your mortgage points.
Of course, what you really want to know is how much your rate will drop with each point you buy. According to the National Association of Realtors (NAR), a point reduces your interest rate by between 0.125 percent and 0.25 percent. The deal you get depends on your mortgage terms and the lender. However, NAR says 0.25 percent is typical.
Let’s say you’re getting a 30-year mortgage for $225,000. Your interest rate is 4.15% and each point reduces your rate by 0.25 percent. If you decide to pay two points ($4,500), your rate will drop 0.50 percent to 3.65%.
That seems like a good deal — especially if you plan on staying in your home for a long period of time. But before you jump at paying for points, always run the numbers.
Whether or not paying points is worth it depends entirely on your plans to buy a house. In general, the longer you plan to stay in the home, the more likely you are to benefit from paying points.
Consider the above example. Using a mortgage calculator, you can figure that sticking with the 4.15% rate will result in a monthly payment of $1,094. Over the course of 30 years, you will pay almost $164,000 in interest.
Now, what happens when you pay that $4,500 to buy down your mortgage rate? Your monthly payment drops to $1,029. That seems like only a small difference, but you end up saving more than $20,000 in interest over the life of your mortgage. If you stick with it for 30 years, there’s no doubt that spending $4,500 now to buy down your mortgage can save you big bucks.
But what if you don’t stay in the house for the full 30 years? You’re saving $65 a month with your lower mortgage rate, totaling $780 per year. At that rate, it will take almost six years to break even with your original $4,500 point purchase. If you plan to move after a few years, paying that much up front to reduce your mortgage rate might not be worth it.
What if, instead of paying mortgage points, you just increased your down payment by $4,500?
You borrow $220,500 instead of $225,000. Could that be a better use of your chunk of change?
In this scenario, your monthly mortgage payment would be $1,072, saving you $22 a month. At that rate, it will take you 17 years to break even. Over the course of 20 years, you won’t even save $3,000 in interest over your original loan amount.
In this case, if you have extra money to put toward your home purchase situation, the numbers indicate you’ll save more if you use the money to reduce your interest rate rather than increase your down payment.
Maybe you don’t put that money into the home purchase at all. If you know you’ll sell your house within 10 years, it might make sense to invest the money instead.
Assuming an average annual return of 8 percent, you could end up with $10,009. That’s your $4,500 earning $5,509 just by sitting there.
Of course, when you invest, you run the risk of loss. But buying a home comes with its own risks. Plus, when you invest the $4,500 is more liquid, rather than being tied up in a home.
The key is to consider your options, lifestyle, and how long you expect to remain in the home. Try to figure out the best use of your money by running different scenarios. In the end, only you know how your resources will be put to best use.
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