The Truth About Mortgage Loan Points

Like many other money-related decisions that consumers inevitably encounter throughout their financial lives, the question of whether or not to pay points when taking out a new mortgage is one with dogmatic opinions on either side of the debate.  A quick web search will turn up compelling reasons both for and against the act.  So how do you determine if paying points is a smart decision for you?

Before I explain my approach for helping consumers make the best choice, let’s first define “point” in a mortgage industry context. One point is equal to 1% of the amount of a new loan and is a fee that is included with the other closing costs and paid when the loan is originated.  For example, on a $200,000 loan, the 1% point loan fee would be $2,000.

In exchange for paying a 1% point fee upfront, borrowers receive a permanent discount to their interest rate.  For fixed-rate mortgages, the discount typically is 125% to .375%.  For adjustable-rate mortgages (ARMs), the discount is often a little greater, usually .25% to .50%.  Most of the time, points are expressed in round numbers (i.e., 1% point, 2% points, etc.) but points can also be expressed in decimals (i.e., .50% points) and as negative numbers. (A -1% point would act as a lender credit toward the borrower’s closing costs.)  Points are always expressed as a percentage of the loan amount, not the purchase price.

In order to determine if it makes sense to pay points, borrowers need to address the following questions:

  1. Can I afford to pay the point(s)?
  2. If so, then how much interest do I stand to save over the expected life of the loan by investing in the point(s) upfront?

In answering the first question, it’s important to be sure that the borrower not only possesses enough money to pay the additional upfront fee, but also has enough money left over to have an appropriate financial cushion.  It’s worth noting that points are eligible to be paid through a credit provided by the seller in a purchase transaction, or they can be financed into the loan amount in a refinance.

Nearly all mortgage professionals can provide a straightforward calculation to help borrowers determine how much interest they may save by investing in points upfront.  Let’s look at a simple example.  Assume the following:

  • Loan amount: $200,000
  • Loan program: 30-year fixed-rate mortgage
  • Rate available with 0% points: 5.00% (principal & interest: $1,074)
  • Rate available with 1% point: 4.75% (principal & interest: $1,043)

The chart below represents an accounting of the points and accumulated interest paid (total cost) at various stages throughout the life of the mortgage.

TCA post1

As the chart demonstrates, if a borrower only elects to keep the loan for three years or less, then paying points would not benefit that borrower.  In fact, by not paying points and accepting a higher interest rate, the borrower would pay approximately $500 less ($29,338 versus $29,843) on the mortgage.  However, if the borrower plans to hold the loan for its entire term, then he or she would save nearly $9,000 ($177,586 versus $186,512) by investing in a point upfront and obtaining a lower fixed rate.

In general, the longer a borrower intends to keep a mortgage, the more sense it makes to pay points.  Furthermore, a borrower who is more focused on creating a low payment may value the cash-flow savings of paying points more than the long-term cost-benefit analysis.

Paying points typically does not make sense for borrowers who intend to pay off their loans at a faster pace than the amortization schedule or for those who plan to only keep the loan for a short period of time.

Another important consideration in the points decision is the time value of money.  Simply put, a dollar saved today is worth more than a dollar saved in the future.  For borrowers who prefer a truly comprehensive comparison, I recommend discounting the future cash-flow by an appropriate rate (i.e., the historical inflation rate).

In summary, there is no universal right or wrong answer as to whether or not paying points makes sense; the situation is different for each borrower.  To make a prudent decision, consider your current financial state, the savings you may or may not gain from paying points upfront, how long you’re likely to hold onto the loan, and how quickly you plan to pay it off. You can always ask for help from a mortgage professional—that’s why we’re here.

Making An Offer As Competitive As Possible

If you are a prospective homebuyer in the Portland housing market then I don’t need to tell you how competitive it is. The most recent Case-Shiller Home price Index showed that Portland leads the nation in year-over-year home price appreciation and a separate study released by United Van Lines showed that we lead the nation in attracting new residents.

The impact in our housing market is that there is very strong demand and not enough supply to accommodate it. These conditions will likely evolve over time but for now it is making it hard for homebuyers to compete.

I will be writing a series of posts that will outline strategies a prospective homebuyer can do to optimize their chances in having their offer accepted by a seller.

Here are the topics I will be covering:

  1. Completing & Communicating a comprehensive pre-approval
  2. Know your limits
  3. Accommodate the sellers’ timeline
  4. Eliminating a home sale contingency
  5. Buy the home then do the mortgage
  6. Avoid FHA & VA
  7. Let the lender pay your closing costs

Do you have any ideas for getting your offer accepted? Please comment below.

How reliable is my pre-approval?

This article is coming soon!

How can I refinance my home loan with no closing costs?

For most of our clients, the idea of a “no closing cost” (NCC) refinance seems too good to be true. We think that these loans are great tools for helping our clients save money; but it is critical that our clients understand how they work. The purpose of this posting is to explain how we can offer NCC refinances and how we use them to help our clients manage their mortgages most effectively.

The first thing to understand when it comes to NCC refinances is how they are even possible. As a mortgage lender, there are two ways in which we can generate revenue for our work in originating a new mortgage. The first and most common way is by charging an origination fee to our clients, also known as “points”. Some lenders charge a 1% point in addition to standard closing costs (lender, appraiser, title/ escrow, etc.).

Believe it or not you can refinance your home without upfront closing costs.
Believe it or not you can refinance your home without upfront closing costs.

The second way we can generate revenue is by selling the servicing rights of a loan we originate. In other words, lenders are willing to pay us a fee in exchange for the stream of payments that our clients pay as a part of their mortgage obligation. NCC refinances become possible when we can use the revenue from the sale of the servicing rights to cover all of the closing costs that our client would normally incur.

So what is the tradeoff? The tradeoff is that in order to generate enough revenue to make a NCC refinance feasible, we have to assign a premium to the interest rate above what a borrower could lock in if they were willing to pay their own closing costs.

As an example, here is list of available 30 year fixed rates with the associated closing costs:

4.75% w/ $3,500 closing costs + 1% point ($3,500)= $7,000 closing costs

5.00% w/ $3,500 closing costs

5.25% w/ $0 closing costs (in fact there is a $3,500 lender credit that is used to offset the $3,500 in costs)

For most of our clients it can be difficult to justify the standard closing costs associated with a refinance because the fixed rate being offered is only modestly better than their current situation. For example, for a client who has a current fixed rate of 5.50% the 4.75% would only create approximately $3,000 in annual interest savings & the 5.00% option only about half that. A borrower would need to hold the mortgage for over 3 years in order to save enough interest to recoup the closing costs associated with these options. For most people the “break-even” period is simply too far away to make the proposed refinance attractive.

However, this person could take advantage of our NCC refinance option @ 5.25% and immediately begin saving approximately ~$800 per year. This amount would not change their life but the fact that they incurred $0 closing costs to obtain the new rate would make it beneficial to them from day 1.

Here are some FAQ’s we’re commonly asked about NCC refinances:

Should we wait to see if rates go lower?

The best part about NCC refinances is that typically we can continue to provide them. If a borrower took advantage of the aforementioned 5.25% option and rates continued to decrease over the following months we could always provide another NCC refinance in the future. Since there is no cost to them there is no drawback in doing it multiple times, even within a short time period. We call this the “ratchet effect” because we effectively “ratchet” your mortgage rate lower as long as it makes sense but the rate will never move higher from the fixed point.

Will we have to bring any cash into closing?

It is likely that you’ll have to bring some money into closing. The amount will vary on a case-by-case basis but lenders will essentially collect what equals to one mortgage payment because by refinancing you’ll skip your next one. For example, if you closed the NCC refinance on June 15th you’d be responsible for the interest on your current loan from the date of your last payment (June 1st) to the 15th (when the loan would be paid off). You would also be responsible for the interest that will accrue on the new mortgage from the close date, to the last day of the month (June 15th –June 30th). You WOULD NOT have to make a mortgage payment on July 1st.

Depending on whether or not you pay your real estate taxes & homeowner’s insurance with your monthly mortgage payment, the lender may also need to collect funds to re-establish a tax/ insurance reserve account. Often times these amounts can be included in your new loan amount so that you don’t have to fund this with cash out of your pocket. Keep in mind that when you pay-off your existing mortgage the lender will refund any amount that you currently have on deposit with them and therefore this amount that is collected is effectively a “wash”.

If you pay your real estate taxes and homeowner’s insurance separate from your mortgage payment then the lender may require that your current homeowner’s insurance be renewed (if it set to be renewed within the next few months) or any outstanding real estate tax liens be paid (depending on the time of year).

Will my loan amount change?

Some of our clients have asked us if when talking about a NCC refinance we are simply referring to “rolling” the cost of the loan into the new loan amount. We are not. This is truly a NO CLOSING COST refinance. If you’re comfortable paying your equivalent of one mortgage payment at closing and possibly any collected taxes and insurance then we can keep your loan amount exactly the same.

Does my 30-year term on my mortgage start over again?

It is true that with the new mortgage your term will start over again (there are some exceptions). However, if paying off your mortgage is most important to you then it would still be in your best interest to complete a NCC refinance. This is because if you used the monthly payment savings that you’ll get from the refinance to pay additional principal each month you’ll pay off your principal quicker than your current mortgage with a higher interest rate.

Are NCC refinances available to everyone?

NCC refinances are tougher to offer for borrowers who have loan amounts < $250,000.

Do Bi-weekly payment programs make sense for me?

I am often asked by customers whether or not signing up for a bi-weekly repayment plan is a good idea. So that this post doesn’t exceed 10,000 words I am going to ignore the first question to ask which is “should I be in a hurry to pay off my mortgage?” given that you probably have a low fixed interest rate which carries tax advantages. In other words, are their other financial goals that deserve more attention (i.e. building a liquid savings account for security, paying off other debts, boosting retirement savings, boosting college savings, etc.)?

In general I oppose the bi-weekly payment plans because I think the companies that offer them deceive consumers. Here’s why:

With bi-weekly payment programs the lender or a 3rd party servicer will typically charge $250-$500 to sign up for the program. They will then automatically draw one half of your total monthly payment every 2 weeks and apply it to your mortgage. The marketing materials for these programs lead consumers to believe that the reason they are paying down their principal quicker is because they are paying one half of their mortgage payment earlier in the month and therefore avoiding interest on that portion of their mortgage payment during the second half of the month. But this is not accurate.

The reason that a bi-weekly plan accelerates the principal reduction on your mortgage quicker than the regular amortization schedule is NOT because you’re making the payment earlier in the month but because you are making 13 payments per year instead of 12 (there are 52 weeks in a year, 26 bi-weekly periods, and therefore 13 total payments made).

With that said, any consumer can create the very same impact by simply making one extra payment per year or by increasing your monthly mortgage payment by 1/12th of your principal and interest payment. For example, if your monthly principal and interest payment is $1,200 per month then you could add $100 per month (1/12th of $1,200) and have the same impact as the bi-weekly payment program without signing up or paying a fee.