Rates and Points Explained – Lower Isn’t Always Better
The Confusion With Rates and Points
Borrowers are often confused about mortgage rates and points when deciding which home loan option is right for them. Traditionally, people simply want the lowest rate. But picking the lowest rate is not always the smartest financial move.
Interest Rates and Points Defined
Everyone knows what an interest rate is. It is a percentage "fee" charged by lenders for making a loan. The amount of interest you pay is based on the loan amount times the interest rate.
Example: $100,000 loan at 5% interest = 100,000 x 5% = $5,000 per year interest.
Points, though, are not always understood. "Point" simply means "percent", and is an up front fee that a lender charges for making a loan, based on the loan amount.
Example: $100,000 loan with 1 point = 100,000 x 1% = $1,000 up front fee.
Points are also referred to as "discount points" or just "discount". Whatever you call it, it's money out of your pocket at closing.
How Are Interest Rates and Points Determined?
The money for most mortgages comes from the sale of mortgage bonds. Much like the stock market, the bond market fluctuates constantly. This bond market fluctuation ultimately determines the minute-by-minute interest rates and points.
So here's how it works... Mortgage investors dictate a rate that they want at any given moment. Let's say 5%. Now, three things can happen:
1. The borrower accepts 5%. Since the investor got exactly what he wanted, the borrower doesn't owe anything else. The borrower pays NO points, known as "Par Pricing".
2. But what if the borrower wants 4.5%? The investor won't accept that, as he wants 5%. However, the investor will let the borrower pay less interest IF he gets extra money up-front. He figures out that x points, plus that 4.5% interest will yield him the same as the 5% he wanted. So this scenario is a loan priced at a "Discount".
3. Now, suppose the borrower takes 5.5%, which is more than what the investor wanted. The investor will give the borrower a credit, like an up-front refund, as the interest will be higher than required. This loan is priced at a "Premium" or "Rebate", and the credit can be used to pay the borrower's closing costs.
Lower rates can be obtained by paying discount points.
Higher rates will result in a credit to the borrower for closing costs.
The par rate is in the middle, with no points or credits.
What's the Best Combination of Rates and Points?
So the borrower is given some choices of rates and points to pick from. How should he choose?
The first factor in deciding may simply be cash flow. If the borrower wants to reduce closing costs, taking a higher rate and paying no points, or even getting a credit, may be the best option.
But what about a borrower without closing cost restraints?
The single most important consideration in choosing rates and points is time. That is, how long the loan will be in existence. In order to make a wise decision, we need to know how long the borrower will keep the loan.
Getting a lower rate means getting a lower monthly payment. But it requires an up-front investment (points). A "break-even analysis" is done to figure out what options make sense.
Don't worry... this isn't difficult!
To compare two rate and point options, divide the cost for the lower rate by the monthly savings in the payment.
Borrower has two options for a $100,000 loan:
Option 1: 5% rate, no points, $536.82 payment
Option 2: 4.5% rate, 1 1/2 points, $506.69 payment
So, if the borrower takes Option 2 for the lower rate, it costs $1,500 in points to save $30.14 per month.
$1,500 divided by $30.14 = 49.77 months
It takes 50 months, over 4 years, just to get the initial investment back from the lower payments. This is the "break-even point".
Is the investment worth it? If they plan on having the loan for 30 years, then they may choose the lower rates and points. But what about a borrower that only plans to be in the home for 4 or 5 years? In that case, it makes sense to take the higher rate and save the money as it would be a losing investment.
We make investments in order to make a profit. Think of the rates and points combination as an investment. Without considering time, a borrower cannot make a wise investment choice. And, as you've seen, a lower rate is not necessarily better!
Any question? Please call Ludwig Parsamian, Keller Williams at 818.281.5889 or Karyn Weger, Sr. Loan Officer and Branch Manager at 909.499.8949