Mortgage shoppers naturally want to lock in the lowest
possible. However, the fees associated with your loan are an
important reason why you shouldn't shop for a mortgage simply based
on the lowest interest rate available.
How points affect your interest rate
The largest set of fees associated with any mortgage are what's
, which can -- and do -- affect the interest rate on your loan. If
you're willing to pay what are known as "discount" or "origination"
points, you can reduce or "buy down" your interest rate. On the
flip side, there are also "rebate" or "negative" points. The way
rebate points work is that if you can't or don't want to pay your
closing costs out of pocket, you can take a higher-than-market
interest rate that will substantially reduce or even zero out your
"You can take a loan with no closing costs, but what you're
asking is to finance those costs," says Justin Lopatin, vice
president of mortgage lending at PERL Mortgage in Chicago. "You're
taking a slightly higher rate, and you're paying the costs every
month in that rate."
A point is an upfront fee equal to 1 percent of your loan
amount. For example, if you borrow $200,000, one point is $2,000,
half a point is $1,000 and a quarter point is $500.
As a general rule of thumb, a discount point paid today usually
shaves no more than a quarter or eighth of a percentage point off
your rate. The ratio isn't constant and changes with market
conditions, interest rates and between lenders.
Pros and cons of paying points
There are several pros and cons to paying
. When market rates were higher than they are today, paying a point
to lock in a lower rate often made sense. That's not the case
today, however, because rates are near historic lows so the
relationship between the cost of a point and the rate reduction
doesn't pencil out, says Lopatin.
However, anytime you can pay less interest, you allow yourself
the chance to qualify for a larger loan, build equity faster and
can save thousands in interest over the life of the loan. But
again, it all comes down to how much cash you have available or
wish to spend on your mortgage.
Some people insist on paying points to get a lower rate even
though it's less advantageous, says Gary Parkes, vice president of
mortgage lending at Guaranteed Rate in Atlanta.
"If you really want that lower rate, we will give it to you, but
it's going to cost you," he says. "It becomes psychological, not an
economic or financial decision."
Points impact interest, equity and loan size
A little math illustrates the influence of points on your loan's
interest, how quickly you build equity and the amount of money you
can qualify to borrow.
Let's say you have been approved for a $200,000 mortgage at 3.50
percent with no points. For the sake of this example, we'll assume
that one point will raise or lower your interest rate by 0.25
percent. You have three options:
- Pay one discount point in addition to your closing costs for
a lower interest rate of 3.25 percent
- Pay no points at all, leaving your interest rate unchanged at
- Receive one rebate point, $2,000 at closing, in exchange for
an interest rate of 3.75 percent. Whether you wish to apply that
$2,000 to your closing costs or not is your choice.
By paying the one point, your savings of improved equity and
lower interest netted you $2,427 over a seven year period.
Receiving the one rebate point cost you an additional $2,418 in
interest and lost equity.
Paying points to get a lower interest rate can also allow you to
borrow much more mortgage on the same amount of income. That larger
loan size can be the difference between competing for a larger,
more desirable home in a neighborhood with better schools. Using
our interest rate examples above, you'll be able to borrow an
additional $24,174 at 3.25 percent as opposed to 3.50 percent.
Paying points on an ARM
Paying a point on an ARM can have multiple benefits. For one, it
lowers your monthly payment. But more importantly, it provides you
some additional protection against any future period of high
interest rates. This is because your "caps" (limits on interest
rate changes) are based upon the loan's original interest rate.
Income tax implications
One factor that's often missed in the discussion is the income
tax treatment of points, says Andrew Kalotay, president of Andrew
Kalotay Associates, a New York-based research and analytics
Points paid to obtain a mortgage may be tax-deductible, but
various rules and limitations
. The tax treatment differs depending on whether the loan is
purchase-money or a refinance.
HSH.com's mortgage calculator can help you plug in the different
interest rates to see how paying points will affect your overall
interest payments. Remember, the lowest rate mortgage may not be
the lowest cost mortgage, so you should take the time to do the
math to see how points impact your loan.
Again, each borrower's financial situation is different, so the
decision to pay or not pay points comes down to the cash reserves
you have available at closing.