Should You Pay Points?

Should you pay "points" to get a better rate?

Do you plan on keeping your loan for a while? Then it may make sense to "buy" a lower interest rate by paying one or more "points."

Even if you're unsure of how long you plan to keep your mortgage before you move or refinance, paying points now for a lower rate may make sense. For example, do you have a high-paying job now but you think you might change careers in the next few years? Talk it over with a qualified Mortgage Planner. It's part of a Mortgage Planner's job to help you find the right loan for your means and goals.

Points are normally tax deductible whether you or the seller actually pay for them. Points on a refinance are not deductible in the same way. On a refinance you normally have to spread your deduction out over the amortization of your loan (check with your tax advisor).

If you look at a comparison of 2 different loan programs, one with points and one without points, laid out by a mortgage professional, you will be able to see your total cost of the loan for each program. The most important factor here is the amount of time you plan to hold this property before refinancing or selling. This will help you make the decision rather quickly.

For borrowers with ample cash and low return on investment for their cash, paying additional points to buy down an interest rate may be a good idea. One should always consult with a loan officer to analyze the cost of the buy-down and the amount saved with the lower buy-down rate over the life of the loan. A knowledgeable loan officer can show a homeowner the number of years the homeowner needs to keep the loan in order to recoup the cost of the buy-down, and thereby allowing the homeowner to make an informed decision.

There are basically two types of buy-downs, a permanent buy-down and a temporary buy-down. A permanent buy-down entitles the homeowner to a lower interest rate for the life of the loan. A temporary buy-down gives the borrower a lower interest rate for the first two or three years of the loan term. A common temporary buy-down is the "2-1 Buy-Down", which gives the homeowner a discounted rate of 2% below his mortgage note rate in the first year of the loan, 1% below the qualified note rate in the second year, and the note rate for years 3 to 30. For example, consider a borrower qualifying for a 30-year fixed rate mortgage of $200,000 at 7% interest rate, with the option of a 2-1 Buy-Down that costs 2.25 points, without the buy-down, the borrower's monthly payment would be $1,330 for the life of the loan. With the 2-1 buy-down, at the cost of $4,500 (2.25 points = 2.25% of the loan amount), the borrower interest rate for the first year is 5% (2% below qualified note rate of 7%) and the monthly payment for the first year is $1,074, 6% (1% below note rate) and a monthly payment of $1,199 for the second year, and 7% (qualified rate) and monthly payments of $1,330 for the remainder of the loan term.

Another commom Temporary Buy-Down is the 3-2-1 Buy-Down, which works very much like the 2-1 Buy-Down, except in that it gives the borrower 3% below qualified rate in the first year, 2% below in the second year, 3% below in the third, and the normal note rate for the rest of the loan term.

When deciding weather or not to pay points to get a lower rate you should also look at your “break even point”. One point is equal to 1% of your loan amount. If paying that extra point lowers your rate then your savings are in a lower monthly payment. The break-even point is the amount of time it takes for that monthly savings to exceed the total initial investment of the point. When comparing different loan scenarios and options with your mortgage broker, have them calculate your break-even time for each scenario. You want the break-even point to be shorter than the amount of time you plan to spend in that mortgage (if you plan to sell or refinance in the future)

If you are tight on funds for closing opting for a loan with the lowest upfront cost and no discount points may cost may be right for you. Over the life of the loan you may be paying out more money however enabling you to provide for your families immeditate needs.

Paying points to get a lower rate when refinancing into a long term fixed mortgage often makes good sense. The points can normally be financed into the loan instead of paid out of pocket. Over the long haul, money saved from the lower interest rate will more than make up for the principal added by the points.

When you pay "points," you pay interest in a lump sum upfront to get a lower rate on your fixed rate mortgage. Each point costs 1% of the mortgage amount. The more points you pay, the lower your mortgage rate. So, which is the best for you? More points and a lower rate? Or fewer points and higher rate? To decide, you need to consider: (1) Whether you can afford to make the upfront payment now for points. (2) The length of time expect to have the mortgage. The longer you plan to have your mortgage, the more it makes sense to pay for points now because you'll have a long time to benefit from the lower rate.

Paying points may decrease your debt to income ratio

You should also seek the services of a qualified tax consultant regarding the tax consequences of prepaid interest.

The most common buy down is the 2-1 buy down. In the past, for a buyer to secure a 2-1 buy down they would pay 3 points above current market points in order to pay a below market interest rate during the first two years of the loan. At the end of the two years they would then pay the old market rate for the remaining term.

As an example, if the current market rate for a conforming fixed rate loan is 8.5% at a cost of 1.5 points, the buy down gives the borrower a first year rate of 6.50%, a second year rate of 7.50% and a third through 30th year rate of 8.50% and the cost would be 4.5 points. Buy down were usually paid for by a transferring company because of the high points associated with them.

In today's market, mortgage companies have designed variations of the old buy downs rather than charge higher points to the buyer in the beginning they increase the note rate to cover their yields in the later years.

As an example, if the current rate for a conforming fixed rate loan is 8.50% at a cost of 1.5 points, the buy down would give the buyer a first year rate of 7.25%, a second year rate of 8.25% and a third through 30th year rate of 9.25% , or a three quarter point higher note rate than the current market and the cost would remain at 1.5 points.

Another common buy down is the 3-2-1 buy down which works much in the same ways as the 2-1 buy down, with the exception of the starting interest rate being 3% below the note rate. Another variation is the flex fixed buy down programs that increase at six month interval rather than annual intervals.

As an example, for a flex fixed jumbo buy down at a cost of 1.5 points, the first six months rate would be 7.50%, the second six months the rate would be 8.00%, the next six months rate would be 8.50%, the next six months rate would be 9.00%, the next six months the rate would be 9.50% and at the 37th month the rate would reach the note rate of 9.875% and would remain there for the remainder of the term. A comparable jumbo 30 year fixed at 1.5 points would be 8.875%.

While it is not a traditional means to do business, a great broker will be honest and upfront to you about the points they receive on the front (points paid by the borrower at closing) and points on the back ("yield spread" points paid by the lender at closing). Generally these points are all revealed at closing, so it can be helpful to negotiate this prior to that date.

When paying points you should take into consideration that you are basically paying interest upfront to have a lower rate and payments during the life of the loan. If you plan to have the loan for a long time this can be a good idea.

Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, 2 points means a payment of $2,000.

» DISCLAIMER: The information contained in this article on 'Should You Pay Points?' is a collection of contributions by licensed mortgage professionals and is not the opinion of Broker Outpost LLC. Always consult a licensed professional before applying for a mortgage.