Many borrowers ask the question: Is it in our
best interests to pay upfront points when buying
or refinancing a home? Short answer: it depends.
There is no hard and fast rule.
It’s a shame that many misguided “rule of thumb”
answers are still circulating at the family
barbeque or being touted within the trusted
walls of the accountant’s or attorney’s office.
The real answer depends mostly on the borrower’s
plans for remaining in the home and their budget.
There is a simple test that a borrower can conduct
themselves to see what’s best for them. Read
on.
First...what are “points”? A point is one percent
of the loan amount, paid by the borrower at
closing. This percentage can be paid either
out of their pocket upfront, or taken directly
out of the proceeds of a refinance loan. One
point paid on a $200,000 loan would cost a borrower
$2,000, two points would cost $4,000, etc.
So, a point typically means that more money
is required at closing. So why pay points? What
advantage does that give the borrower?
Just as you consider the bird in the hand to
be worth two in the bush, so does the lender.
With the assurance of points paid upfront, the
lender is willing to offer a lower interest
rate to the borrower. In other words, points
can be used to “buy down the rate”. On a long-term
loan commitment, the one or two percent paid
upfront can mean tremendous savings for the
borrower over the lifespan of the loan, due
to lower interest rates against a large principal
sum.
The most common misconception among borrowers
is that no points upfront equals a better deal
for them. This common bias against paying points
can actually work against the best interests
of the borrower. The real answer depends on
three variables:
- How much lower is the rate as a result of
paying points upfront?
- How long does the borrower have to stay in
this mortgage to recoup and ultimately come
out ahead?
- And finally, if the borrower is planning
on holding the loan past the break-even point,
can they afford to lay out the money to pay
the points comfortably?
A loan without loan origination points paid
carries an inherently higher rate and therefore
a higher monthly payment. So, if a borrower
pays points the closing fees will be higher,
but the monthly payment will be lower, thus
creating the “break even point” for having paid
points.
The break-even point is the time after
which the investment of points to “buy down
the rate” is overcome by the accumulated monthly
savings which result. If the borrower then holds
the loan past this moment, paying the loan origination
points becomes a good investment and saves the
borrower money. If however, the borrower refinances
the loan or pays off before the break-even point,
paying the points becomes a financial loss.
Here's an example using a $200,000 purchase
mortgage:
a) $200,000 (0 points paid) @ 6%
= monthly payment $1199
b) $200,000 (1 Point paid, $2,000 upfront)
@ 5.5% =monthly payment $1135
Option b costs $64 dollars per month less
than option a. Therefore; the $2,000 in points
will break-even in 31 payments. Each payment
beyond payment 31 saves the borrower an additional
$64 above the cost. If this borrower held
this loan for the remainder of the thirty
years paying points would have netted them
a total savings of $21,056. This is a huge
benefit for the borrower.
What borrowers must avoid at all costs are “rules
of thumb” such as “never pay points” which simply
ignore beneficial strategies that can really
pay off for a borrower under the right circumstances.
These rules are oversimplified and meant to
cover all situations and borrowers in exactly
the same way. And they are wrong.
Instead of hurting yourself by ruling out origination
points, ask your loan officer a series of questions
to see whether it's the right move for you.
a) What are my point options?
Have your loan officer make a spreadsheet that
maps out upfront costs, rates, and payments
for loans with 0,1, and 2 points. Calculate
monthly savings difference in options and determine
a points-paid/break even point in number of
months.
b) Next, ask yourself, how long do I realistically
expect to hold this loan? Do I have any reason
that I know I will be selling my home soon or
a planned refinance at a particular point? Is
this timeframe shorter than the break-even point?
If you plan to hold the loan beyond the “break-even
point”, it makes sense. If not, no points should
be paid.
c) Can I afford to pay for the points on my
purchase loan or out of the proceeds of my refinance?
Here you have your answer.
What gives rise to the dogma that says “never
pay upfront points” in the first place? After
all, every borrower wants the best deal, don't
they? So why cast out what may be a tremendous
tool for savings in the borrower's arsenal?
Well, it’s a fact that some banks and brokers
simply charge a higher premium for their services
for the exact same product. Leveling the playing
field here is simply a matter of a side-by-side
comparison.
Although present laws do not require lenders
and brokers to guarantee your actual price until
the time of closing, it is advisable to borrowers
get a complete loan application, fee agreement,
truth in lending statement and good faith estimate
from your loan officer as early as possible
in your process. As long as both companies have
included an accurate representation of fees
that you will see at the closing and the loan
programs and options within the programs are
the same you can choose the lower A.P.R. and
know you’ve taken the better deal. When doing
such a comparison, compare the following side
by side:
a) Loan amount
b) Term of loan
c) Loan type
d) Upfront points
e) Pre-payment penalties
f) Rate Lock period
g) A.P.R (Annual percentage rate)
h) Closing fees
If a proactive borrower follows these guidelines,
does their homework and levels the playing field,
intelligent loan buying decisions can be made
systematically. A federal “Truth-In-Lending”
disclosure will help you level the playing field
between lenders, by allowing you the opportunity
to compare the A.P.R. or annual percentage rate,
which represents the real cost to borrow. Check
that the A.P.R. at closing is not significantly
higher than the A.P.R. on your original application.
Borrowers often inquire about other pricing
differences that derive from different products
(for example variable vs. fixed rates) as well
as product options s(uch as taking on pre-payment
penalties, balloons and interest only payment
options). All are legitimate ways for a borrower
or bank to manipulate rates to fit a particular
need.
Unfortunately, lack of understanding by both
borrowers and loan officers, and misapplications
of these methods often interfere with clients
ability to use these options in their favor.
Just like paying points -- there are times to
use any of these options and borrowers should
be willing to explore such options with an open
mind, but cautious of the ramifications if they
are not applied properly.
