When you are shopping for a mortgage loan, interest rates are most likely at the top of your mind. As you shop lenders for the best rate, however, you will hear another term linked to the interest rate. That term is “points.” For instance, a lender may quote an interest rate of 5.25 percent plus two points. As a borrower, you need to understand the concept of those points and how they relate to your interest rate and mortgage loan.
So what are points? Points are fees paid up front to the lender in exchange for a lower interest rate on a mortgage loan. Paying points lowers your mortgage rate because the lender is getting a prepaid portion of the interest rather than collecting it in payments across the term of the loan.
Because points are used to essentially “buy down” the mortgage interest rate, they are commonly referred to as discount points. These discount points are paid at the time the loan is closed. They can be paid by the buyer/borrower or seller, or split between the two. Who pays the points depends on what is negotiated in the purchase contract and what is allowable under the terms of the mortgage loan.
Expressed in terms of a percentage, each point is equal to one percent of the total mortgage loan amount. Consequently, on a $200,000 loan, one point would cost $2,000. Using that loan amount and the rate/point combination mentioned earlier of 5.25 percent plus two points, here is an example of how points work:
- The lender would offer a higher rate if no points were paid. Assuming the rate is lowered one-eighth of a percentage point for each discount point paid, the higher rate in this case would be 5.5 percent.
- Paying two points would cost $4,000 ($200,000 times two percent) and would reduce the interest rate to 5.25 percent.
Keep in mind that the specific reduction for one discount point varies with different loans and from lender to lender as they have some flexibility in determining the buy down formula.
Is there a benefit to paying points? Now, how do you know if paying points to lower your rate is to your advantage? You will need to consider a number of factors. These include what you can afford to pay up front, how long you plan to keep the home, and how long it will take you to recover the cost of paying points.
Your mortgage lender will help you do the math for monthly payments, monthly savings, and recovery time. If you are Internet savvy, you can get a jump-start on the process by using one of the readily available online mortgage calculators specifically designed to calculate discount points. To give you an idea of what numbers you can expect to see, here is a comparison of the loan from our earlier example with no points and with two points. The loan amount is $200,000 with a 30-year term.
- Monthly payment at 5.5 percent with no points would be $1,135.58. Total interest paid would be $208.806.98.
- Monthly payment at 5.25 percent with two discount points ($4,000) paid at closing would be $1,104.41. Total interest paid would be $197,585.34.
By paying two points, you save $31.17 per month on your payment. It will take approximately 128 months (about 11 years) before the amount saved is greater than the cost of the two points. Therefore, paying the two points would be an advantageous option if you plan to keep the home more than 11 years.
Your decision on whether or not to pay points can impact your rate, your monthly payments, and your interest savings in the long run. As you can see, that decision involves a number of personal and financial considerations. Add to that the variety of rate and point combinations that lenders offer, and it is obvious why it is important as a borrower to understand how discount points work.
Use that understanding to decide how you would like to handle points before you begin shopping for a mortgage loan. Then it will be easier to work with your mortgage professional to determine whether a lower rate with more points or a higher rate with fewer or zero points is in your best interest.