Should You Pay Points?
When getting a mortgage, one of the most important things to pay attention to is the cost of the loan being applied for. There are certain fees customers can shop for that may be drastically different from one lender to another (for example, discount points, and lender fees) and some fees that are the same or very similar regardless of which lender is used for the transaction (title insurance and government recording charges, for example). One fee that can vary drastically from one lender to another are “points” being charged.
What is a “Point”?
In mortgage (and more generally, financial) jargon, a “point” is a percentage of the loan amount being borrowed. For example, 1 point = 1% of the loan amount. If a borrower applies for a $400,000 loan, a point would cost $4,000. On an $800,000 loan, that cost increases to $8,000. There’s a $4,000 difference, but both examples are with a charge of 1 point. Many lenders offer options with fractions of points as well, so you may see things with a cost of “half a point” or “a quarter of a point”, which would just be a fraction of that 1% charge.
Why pay points?
There are 2 reasons lenders charge points – profit, and savings. For profit, lenders can charge points as a source or revenue, and for savings, customers can pay ‘discount points’ to obtain a lower interest rate. Most lenders offer what is called a “par” rate, or a rate that doesn’t cost a customer any fees beyond customary closing costs/origination fees. For additional cost, or ‘discount points’, customers can obtain a lower rate and payment.
When Points Make Sense
There’s no ‘one size fits all’ for the right loan structure, which is why it’s so important to work with an experienced loan officer. That said, it generally makes sense to pay points when a customer is seeking out a longer term loan. If you believe it’s a loan you’ll hold over a long period of time, additional up front costs may be recovered through the savings of lower monthly payments that a lower interest rate can offer. Sometimes, depending on the market, a lower rate may be fairly affordable to obtain. Markets change daily, as does the cost for different rates, but as a very general rule, the cost to buy the interest rate on a mortgage loan down by .25% is usually 1 point. So if the ‘par’ rate is 4%, a customer may be able to get a rate of 3.75% by paying a point. However, some days the market yields lower cost options. For example, it may only cost .5 points to get that same .25 reduction to rate. In these cases, customers need to decide if it makes sense, but it can be more appealing to get a lower rate with some additional up front costs under these circumstances.
Over the course of time, closing costs in the thousands of dollars are offset by a small reduction in monthly payment, so points up front, long term, can result in savings.
When Paying Points Is a Bad Idea
Again, there’s no definitive “right answer” to this, but generally speaking, paying points on a short term loan doesn’t make much sense, because closing costs occur with every loan. Even “no closing cost” loans (which don’t really exist outside of marketing ploys!) include closing costs, they are just paid via a higher interest rate. So paying points in addition to customary closing costs on a loan, then quickly obtaining another loan with another set of closing costs is very likely going to negate any benefit of additional up front costs. For example, if you pay discount points to get a rate that saves $50/month, but it costs $5,000 in additional closing costs – the breakeven point is roughly 8 years (or 100 months). Paying the loan off early negates the benefit of the lower rate.
This is especially true in an environment where rates are dropping or expected to drop, because if an opportunity presents itself to refinance, paying excessive up front fees on a loan that may be refinanced soon doesn’t always make financial sense. Customers need to think “a lower rate is good, but at what cost does it make sense?”.
One other note on points as a bad idea – sometimes, especially in rising rate markets, lenders still try to market low rate loans to lure customers in with an attractive rate – often times, though, the costs to obtain these lower rates are on the higher side. In these situations, it’s extremely important to read the fine print. That “too good to be true” rate may in fact be just that. If lenders are hiding fees in the fine print (for example, putting a great looking rate in big bold font, then in font you need a magnifying glass to read, stating that the rates comes with 2 or 3 points), that’s usually a glaring red flag.
All in all, paying points when getting a mortgage is part of the decision making process to get the best loan, and the best loan is subjective – for one person, the cheapest loan option may be the best, and for another, a loan with higher up front costs may make the most sense in the long run. “Points” shouldn’t be considered a bad word when getting a loan, but they should be understood, and when they’re being paid, there should be some short term benefit to the person paying them.