As if understanding all the basics of a mortgage like interest rates, amortization, escrow, and PMI weren’t complex enough, there comes one more product that really convolutes the entire process even further: points.
Like all of the items mentioned above, knowing whether or not to purchase points can have significant long-term implications on how much money you may actually save or lose throughout the life of the mortgage. This post is going to explain how all that works and I’ll even give you a Microsoft Excel worksheet to try it out yourself.
What Are Points?
A “point” is just another way of saying “a fee I’m going to pay to the mortgage lender right now to get a better interest rate”. These are referred to as “discount points” because you buy them to discount (or lower) the interest rate on your mortgage.
The way this works is that a mortgage lender will typically offer you a few different options:
• One mortgage offer with a normal interest rate and no points
• Another (or multiple) mortgage offers having different interest rates in exchange for varying amounts of points
In technical terms, a point is equal to one percent of the total loan. For example, if your mortgage is going to be for $200,000, one point would cost you $2,000. The actual amount that this one point will drop your interest rate will vary from lender to lender. It is usually between 0.125 and 0.25 of a percent.
As I found out during our refinance process, points can also work the other way. The lender can credit you points if you agree to take a higher interest rate. This credited money is usually applied towards your closing costs.
Why Bother With Points At All?
We all like to buy things on sale. Points are a little bit like buying your mortgage “on sale”. In essence, you may be able to spend a little bit of money now that will result in huge savings later on down the road. However, just like how not all sales are good ones, there may be some situations where you may be better off not taking any points at all. The only true way to know is to calculate it out.
The easiest way to explain this is to run through a few examples to show you how this could impact your money in the future.
Let’s begin by making up a fictitous scenario. Suppose you need a mortgage for $150,000. You’re offered two options:
• A 30 year fixed rate at 4.25% and no points
• A 30 year fixed rate at 4.00% for 1.0 points
In both situations the initial closing costs will be $3,000. For simplicity, let’s assume that you will not be rolling the closing costs into the mortgage and that you’ll be paying for them separately out of pocket.
Whether or not you buy points will affect three important variables:
1. How much money you pay right now in closing costs
2. How much different your monthly payments will be over the course of the mortgage
3. How much total interest you’ll pay throughout the life of the mortgage
Here is what the table above says about taking the mortgage with points over the one without points:
• You start out losing $1,500 by paying extra in closing costs
• Your monthly payments are $21.79 less
• You save $7,843.28 in total interest by the end of the 30 years
Where It Gets Complicated:
So how does all this information relate to each other?
• In order to compare a one-time amount of $1,500 to $21.79 per month for 30 years, you have to put both numbers on a 30 year timeline. This is often referred to as finding the “future value” of the money. Now if that last sentence put you to sleep, don’t worry – Excel can help you figure this out pretty easily.
• Understand that the amount of money you saved each month in monthly payments is equal to the total interest saved over the life of the loan. Take a look at the math: $21.79 x 12 months x 30 years = $7,843.28.
To find the future value of the difference in closing costs versus the difference in monthly payment, you first need to pick a reasonable return rate. For simplicity, let’s pick the well-known stock market 8% annual rate of return figure. In other words, we’re going to treat this two ways:
• We take the $1,500 and put it away in an investment account untouched for the next 30 years.
• We put the $21.79 away every month in an investment account for the next 30 years.
The Mortgage Example Results:
So given everything above, here are the results:
• The extra money of $1,500 you paid at closing would have grown to $16,403.59. This number is negative because you lost this money.
• The $21.79 you saved in payments each month grew to $32,470.30. This is well above the straight-forward amount of $7,843.28 in total interest saved we were originally making comparisons to.
The net result is an extra $16,066.71 in your pocket. In this scenario, the mortgage with the points wins!
The Refinance Example Results:
Now we’re going to use the same logic to figure out how points affect a mortgage refinance. For fun, I’m going to use the REAL numbers I was recently offered on my 20 year refinance (… as you can guess, I need to know which offer to take, right?).
So in this real example, the following happens:
• The extra money of $1,446 I’ll receive towards closing costs could grow to $7,124.16.
• The extra $19.17 I’ll pay each payment will cause me to lose $11,288.86. This is well above the $4,599.72 in straight-forward interest we’ll pay for taking the higher interest rate.
The net result is that I’ll lose $4,164.71 by taking the discount points. In this scenario, the refinance offer without the points wins!
Show Your Work:
If you’d like to try these examples out for yourself with your own variables, please feel free to download the Excel worksheet I created for these examples.
Have you ever considered buying points on a mortgage? Did you go through the math or just go by what your mortgage lender told you? Was it different from what you learned here? Please feel free to share.
Photo Credit: Microsoft Clip Art