What Are Points on a Mortgage? - dummies

What Are Points on a Mortgage?

By Eric Tyson, Robert S. Griswold

What are point on a mortgage, you ask? The interest rate on a mortgage is and should always be quoted together with the points on the loan. The points on a mortgage used to purchase a home are tax deductible in the year in which you incur them, whereas on a refinance, the points are gradually tax deductible over the life of the refinanced mortgage loan.

Mortgage lenders and brokers quote points as a percentage of the mortgage amount and require you to pay points on a mortgage at the time that you close on your loan. One point is equal to 1 percent of the amount that you’re borrowing. For example, if lenders say a loan costs one and a half points, they mean that if you take the loan, you must pay the lender upfront 1.5 percent of the loan amount as points. On a $150,000 loan, for example, one and a half points would cost you $2,250.

Because no one enjoys paying extra mortgage points costs such as these, you may rightfully be thinking that as you shop for a mortgage, you’ll simply shun those loans that have high points. Don’t get suckered into believing that no-point loans are a good deal. You’ll find no free lunches in the real estate world. Unfortunately, if you shop for a low- or no-point mortgage, you’re going to pay other ways. The relationship between the interest rate on a mortgage and that same loan’s points can best be thought of as a seesaw; one end of the seesaw is the loan’s interest rate, and the other end of the seesaw represents the loan’s points.

So if you pay less in points, the ongoing interest rate will be higher. If a loan has zero points, it must have a higher interest rate than a comparable mortgage with competitively priced points. This fact doesn’t necessarily mean that the loan is better or worse than comparable loans from other lenders.

However, lenders that aggressively push no-point loans may not be the most competitive on pricing. Lenders can price and present a prospective loan to you in many different ways, but never forget that, one way or another, lenders will make sure they cover all their costs. You need to ask a lot of questions to make sure you understand how lenders are charging you for borrowing their money so you can determine the best loan for your needs.

There are technically two types of points — origination Points and discount points — but they both are just points. Don’t let a lender confuse the situation with those terms. Any points paid should get you something — namely a lower ongoing interest rate.

You may be shocked to discover that some people may be better off selecting a mortgage with higher points. If you pay higher points on a mortgage, the lender should lower the ongoing interest rate. This reduction may be beneficial to you if you have the cash to pay more points and want to lower the interest rate that you’ll be paying month after month and year after year. If you expect to hold onto the home and mortgage for many years, the lower the interest rate, the better.

Conversely, if you want to (or need to) pay fewer points (perhaps because you’re cash constrained when you take out your loan), you can elect to pay a higher ongoing interest rate. The shorter the time that you expect to hold onto the mortgage, the more this strategy of paying less now (in points) and more later (in ongoing interest) makes sense.

Take a look at a couple of specific mortgage options to understand the points/interest-rate tradeoff. For example, suppose you want to borrow $150,000. One lender quotes you 7.25 percent on a 30-year fixed-rate loan and charges one point (1 percent). Another lender quotes 7.5 percent (a difference of 0.25 percent) and doesn’t charge any points. Which loan is better? The answer depends mostly on how long you plan to keep the loan.

The 7.25 percent loan costs $1,024 per month compared to $1,050 per month for the 7.5 percent mortgage. You can save $26 per month with the 7.25 percent loan, but you’d have to pay $1,500 in points to get it.

To find out which loan is better for you, divide the cost of the points by the monthly savings . This result gives you the number of months (in this case, 58) that it will take you to recover the cost of the points. Thus, if you expect to keep the loan for less than 58 months (almost five years), choose the no-points loan. If you plan to keep the loan more than 58 months, pay the points. If you keep the loan for the remaining 25-plus years needed to repay it, you’ll save $7,850 ($26 a month for 302 months).

To make a fair comparison of mortgages from different lenders, have the lenders provide interest rate quotes in writing for loans with the same number of points. For example, ask the mortgage contenders to tell you what their fixed-rate mortgage interest rate would be at one point. Also, make sure that the loans are for the same term — for example, 30 years.

This comparison of loans using identical terms will allow you to see whether certain lenders are more competitive than others. Recall that money is a commodity or product just like any other consumer product and that certain money “sellers” (lenders) will be more aggressive with their pricing of their product than others. Your job is to find the lender that offers the product (money) at the lowest price based on your specific needs.