When Should a Borrower Pay Points?
"Points". One of the most oft-spoken terms when speaking with borrowers about their mortgage application. Also one of the most misunderstood concepts that borrowers have with the mortgage industry. I blame the media for this. I also blame lenders & loan officers for not effectively communicating just how much has changed in our industry over the past few years. I also blame Realtors & financial advisors for not fully understanding the concept yet still offering advice, advice that often gets stuck in a borrowers head & leads them to make poor financial decisions. Let's break it down and see if I can explain "points", when they're necessary, and when they should be avoided (it would come as a surprise to most that the answer to 'when they should be avoided' is NOT "always")
A "point" in the mortgage industry, on its most basic level is easy to understand. Quite simply, 1 point is equal to 1% of a borrowers loan amount. A half point? Half a percent. On a $100,000 loan, 1 point is $1,000. On a $500,000 loan amount, 1 point is $5,000. Simple enough, right?
Where things get a little confusing is how points are applied. Some points are pure profit for the lender. Some points are part of a long term planning strategy for borrowers. All points are not created equal.
Since the implementation of the Dodd-Frank act, points no longer directly affect an individual loan officer's compensation since that compensation is now a fixed % of each loan, but points still affect lender's rate sheets and how pricing is offered to consumers. They're still very much a part of important discussions when it comes to how a mortgage fits into a borrowers financial plan. Find a lender that offers rates much lower than anyone else? Chances are, you're paying that lender points to afford them the luxury of those low rates. Find a lender with incredibly low fees and lender credits? Chances are there are points padded into their interest rates.
The majority of lenders these days deal primarily with discount points, so that's where I'll keep my focus. A discount point is a fee that buys down a borrower's rate. Though rates and spreads vary each day, in a typical scenario, the amount a rate is decreased is usually .25 for 1 point. So if the market is offering a rate of 4.25%, a borrower could likely get a 4% by paying somewhere around 1% of their loan amount as an up front fee at closing. This is not a symbiotic relationship so cost/amount saved can vary greatly.
When should discount points be paid?
When planning long term, discount points can be a real benefit. For example, take someone buying their 'forever home' with a 30 year fixed rate loan. Just for this example, let's say it's a $300,000 loan. For 0 points, they can get a 4.5%. For 1 point, they can get a 4.25%. The discount point in this scenario is $3000 and the monthly savings is only $45/month, BUT, long term, the amount of interest paid for the lower rate offers a savings of nearly $16,000.
Is $13,000 over 30 years (the total savings taking the $3000 up front into account) going to be a life changer? Maybe not, but what about the person that does this on 4 or 5 properties? Those savings add up in the grand scheme of financial planning.
When spreads are low between rates, borrowers can also take advantage and pay discount points. Sometimes the bond market brings about rate sheets where buying down a rate with discount points doesn't cost as much as usual. For example, it might only cost a half point to get a .25 reduction to rate. Many times it makes sense to buy the rate down in this situation. When this opportunity arises is usually just dumb luck when rates are in the midst of large fluctuations and volatility (some lenders will be uncertain on which rate to price most competitively, and the result can be several rates priced competitively).
When points are being used to avoid PMI. I often use this strategy when using the LPMI program to avoid a costly monthly burden for borrowers, while also avoiding the permanency of a higher rate that comes along with most LPMI programs.
When should you avoid points?
Any time a loan is short term, paying points doesn't make sense (unless it's the LPMI scenario above and the numbers work out, a good Loan Officer will be able to help with the numbers).
In many cases, it makes more sense in a short-term situation to take a higher interest rate and have closing costs paid for by the lender...but that's another blog for another day.
The "point" is, when beginning to shop for a mortgage, borrowers should avoid 2 thoughts - "I want the lowest rate" and "I'm not paying any points". Points are no longer used by lenders to gouge customers like they were in the past. Points play a role in financial planning and obtaining the best mortgage, and should always be discussed with your lender. Maybe the lowest rate is best for you, or a loan with no points, but maybe a couple discount points could save you a ton in the long run, or a higher rate will benefit you most. Work with your trusted loan officer, and you just might be surprised at which options work best with your plans.