How to Resolve the Great Points vs. Mortgage Rate Debate

By LEW SICHELMAN

When most folks start looking for a home loan their first concern is the interest rate. It's only natural. After all, the mortgage rate represents the single most expensive part of buying a house. Over a 30-year period, you'll probably pay more in interest than you will for the house itself.

But the truth is that you can have practically any rate you want. Seven percent? No problem. Six percent? Sure, we can do that, too.

How is this possible? How can there be such a wide choice in rates, wider even than the mind-numbing array of loans that are available at any mortgage supermarket?

In a word, the answer is "points."

Points represent a one-time fee paid to the lender. The more points you agree to pay at closing, the lower the interest rate. In other words, points are the price borrowers pay for a lower mortgage rate.

A form of interest, a point is equal to 1% of the loan amount. So if you agree to pay one point on a $100,000 loan, the charge is $1,000. If you pay three points, the fee is $3,000.

For some of us, though, this is basically an academic exercise. Many buyers, especially rookies, don't have a lot of extra cash lying around. As a result, they want to cut their closing costs, not increase them. So they will probably want to pay as few points as possible in exchange for a loan rate they can manage.

There's nothing wrong with that. To most home buyers, how much the house will cost each month is a far more important number than either the total price of the house or the rate of interest.

But if you are fortunate enough to have more money than you really need to make a reasonable down payment and cover all the other settlement charges—a move-up buyer who has seen the value of his current house appreciate greatly, for example—you have some important decisions to make.

For, as Richard Novak, a loan broker with Mortgage USA in Orland Park, Illinois, pointed out, "getting the lowest rate isn't necessarily cost-effective." In other words, as Novak and other mortgage professionals will tell you sometimes it pays to pay points.

Let's look at a hypothetical $100,000 mortgage to see how this might play out. And let's say you can obtain the loan at 6.5% by paying 2.25 points, or $2,250 at closing. But if you pay 5.75%—$5,750—you can get a rate of 6%. If you don't want to pay any points, though, the rate will be 7%.

That difference is cash out of pocket. What about the difference in monthly payments? Well, the 6.5% loan will cost you $632 a month for principal and interest. At 6%, your house payment would be just $600. But if you opt for 7%, the monthly payout will be $665.

The monthly savings by taking the loan at 6% instead of 6.5% is $32. But the out-of-pocket cost to achieve that savings is $3,500. If you go with 7%, though, you'll pay $33 more than you would for the 6.5% loan and $65 more than if you went with the 6% mortgage. But there is no extra charge at closing.

Which choice is better? First, and perhaps foremost, it depends on what you can afford to spend every month.

But second, it depends on how long you can reasonably expect to keep the new mortgage. That sometimes translates into how long you plan to stay in the house. But it also brings into question the possibility of refinancing the loan if rates tumble in the future.

Which brings us to the break-even point, the month when you will have saved exactly as much in monthly payments as you spent at closing. And to determine that, simply divide the cost of the points you would pay at closing by the potential monthly savings.

In our example here, the difference in points between the 6% and 6.5% loans is $3,500. So divide that by the $32 in monthly savings and you see that you will break even with the 100th payment.

That's nine years and two months. If you plan to live the place—or keep the mortgage—longer than that, you'll more than recoup your initial outlay in monthly savings, so the better choice is to go for the lower rate and more points.

If you don't plan to keep the mortgage that long, on the other hand, you'd want to choose the higher rate and fewer points. If you live there for five years, for example, you're only out an extra $1,920 ($32 a month for 60 months) instead of $3,500.

Now let's look at the 7% option, in which you pay no points at all. At 7%, you'll pay $33 more a month than at 6.5% and $65 more than at 6%. But you'll pay $2,250 up front to save $33 and $5,750 to save $65.

The right choice? Again, determine the break-even point.

At 6%, you would have to keep the house seven years and four months ($5,750 divided by $65 equals 88 payments) before the extra amount you pay ever7y month adds up to more than the extra amount you'll pay at settlement. If you don't stay that long, you'll save money by making higher payments.

At 6.5%, you'd have to keep the place even longer—107 months—to break even.

So if you expect to move within eight years and 11 months, take the higher payment. If not, pay the points.

Of course, things are never this simple. None of this includes such factors as tax write-offs, inflation or alternative investment options. But, hey, who ever said any of this was easy?

Another approach? You might try to have the seller pay the points. This can be done if you have a solid agent to negotiate for you. Of course, in a raging seller's market, such as we have today, it won't come easy, if at all. But it may be worth your while to pay the amount of the points more for the property. Be sure to speak with your tax attorney, accountant or financial planner.