I’m often asked by clients to explain whether it makes sense for them to pay “points” or “no points” on their proposed mortgage. My automatic response is, “How long do you intend to keep your new mortgage or remain in your home?” Once this question is answered, the decision is easily determined by simple mathematics and how willing or able a borrower is to cover the increased closing costs or refinance into a slightly larger loan.
A “point,” also referred to as a “discount point,” is industry jargon for paying 1% of the loan amount to buy down the rate on a proposed loan. This cost is on top of the standard closing costs involved in the loan process, such as the lender’s processing and underwriting fees, title and escrow fees, etc. As a general rule-of-thumb, when paying a point, a borrower should expect to see a reduction in rate of at least .25%. The amount of rate reduction varies daily and is reflective of market expectations of the value of the loan and where long-term rates are headed. This term structure of interest rates is illustrated in the yield curve which is a graph plotting the relationship between 2-and 10-year Treasury note yields.
The cost of buying down a loan is dictated by the expected life of the loan, which is generally somewhat less than the fixed period, whether an adjustable rate mortgage (such as a 5-year ARM) or a fixed mortgage since a certain percentage of mortgage holders will move to a new home or refinance into a new mortgage before the term expires. (The average life expectancy of a 30-year fixed mortgage is around 7 to 8 years.) In a normal economy, an upward sloping curve is to be expected as longer term money should naturally come at a greater cost. Thus, a 3-year ARM has a lower rate (cost) than a 5-year ARM, which in turn has a lower rate than a 15 and then a 30-year fixed mortgage.
When you buy down the rate you are actually increasing a loan’s life expectancy and steepening its yield curve by enhancing the loan's value. The combination of today’s rock bottom rates and growing inflationary pressures supports a relatively steep curve and limits, to a degree, the benefits of paying a point. Still, given the fact that 30-year rates are at near historical lows, it may be worth buying a lower rate as long as you plan on keeping the prize. The current curve supports the rule-of-thumb minimum rate reduction of .25%, which brings us back to that question of how long one expects to keep the house or not refinance the mortgage. By calculating the payment difference between the “no points” and “point” mortgages you can then divide that amount against the cost of the point to determine how many months it takes to recapture the cost. Here are examples using current 30-year fixed mortgage rates to 80% purchase money for borrowers with good credit:
$417,000 mortgage on a $521,250 purchase:
No points = 5.0% (APR 5.03%). Monthly payments are $2,238.55
One point = 4.75% (APR 4.87%). Monthly payments are $2,175.27
The difference between the two payments is $63.28. Divide the point cost of $4,170 by 63.28 and the cost is recaptured within 66 months or 5 and a half years.
$729,750 mortgage on a $912,187 purchase:
No points = 5.25% (APR 5.27%). Monthly payments are $4,029.71
One point = 5.0% (APR 5.11%). Monthly payments are $3,917.46
The difference between the two payments is $112.25. Divide the point cost of $7297 by 112.25 and the cost is recaptured within 65 months or just under 5 and a half years.
Again, the five-year recapture periods would only make sense if one were holding onto the loan for a longer period of time. Every month thereafter the payment differential would be free money. Another strategy is to apply the higher payment against the reduced, point-secured rate as this will reduce the loan term, saving thousands of dollars. (In the $729,750 loan listed above, this strategy would pay off the loan 22 months sooner, saving $48,000.) On purchase transactions, paying points carries the additional benefit of being deductible against income (along with other non-recurring closings costs) as they are essentially pre-paid interest.
Nicholas Ballard is both a mortgage broker and banker specialized in the residential Marin market. For assistance, please call or e-mail:
Nicholas Ballard: 415-526-1941; firstname.lastname@example.org
Real Estate Financing
CA Dept. of Real Estate #01356374
California Mortgage Advisors, Inc.
CA Dept. of Real Estate #01170868
Redwood Highway, San Rafael