Debt Free

It’s something you see every time you’re in the bank and they have their daily mortgage rate posted in hopes they can turn you down for a mortgage. The bank will have a rate card posted with the interest rate for 30yr and 15yr fixed rate mortgages. In most cases the interest rate they’re quoting for either of these products has been changed, because instead of a straight interest rate, the lender has shown the effect of points on the mortgage. This will be shown by a notation saying something to the effect of “6.05% + 1 1 point” . What does this mean and how does it affect your mortgage?

First of all there are two kinds of mortgage points, origination points and discount points. In this case we’re referring to discount points. A discount point is just a way you can pay a fee at the beginning to lower the interest over the life of the loan. You are, as it’s referred to, “buying down” your mortgage interest rate. Origination points, on the other hand, are a fee charged by the lender to originate the loan. A single point (back to origination points) is a fee equal to 1% of your initial loan balance. So, if your mortgage was for $200,000, 1 point would be a $2,000 fee. You pay this fee up front, at the time the loan closes. This will then lower your mortgage interest rate over the entire term of the loan.

Should you pay discount points on your mortgage? It depends primarily on how long you’ll keep your mortgage loan for. Because the lower interest rate will save you money over the life of the loan, while the fee you pay is paid up front, it will take some time before you will make back the initial money you paid. That is known as the “breakeven point”. After you’ve passed the breakeven point you are actually saving money. Before the breakeven point you’re just repaying yourself the fee you paid the lender for the points when you got your loan.

That means that if you plan on staying in your home (and keeping that mortgage) for a length of time, usually over 10 years or so, points may be a good idea, while for shorter time period you’d be better served investing that money elsewhere. Most mortgage points calculator fail to take into account the value of the money you paid for the points as an investment, only as cash. If you do include the fact that you could easily be earning a return on that money that could possibly exceed the interest savings on the mortgage loan, it changes the equation yet again.

For example, if you have a $200,000 outstanding balance on your mortgage, and you paid 2 points for the interest rate to be reduced from 6.1% down to 5.7% you’ll save approximately $52 a month. How long, at $50 per month, will it take you to recoup your initial investment? Again, that will actually depend on the rate of return you could earn on the money you paid to buy down the mortgage had you invested it instead of using it to pay points.

In this case, if you paid 2 points for the buy down you’ll save about $620 in interest that first year. That $4,000 would have to be invested in a vehicle that returned 14.4% (compounded daily) to earn an equivalent amount. In this example, you’d reach the breakeven point for the loan with points in about 5 years and 8 months. If you held the property and the same mortgage for 15 years, at the end of the 15 years you’d have saved about $5,600, assuming you are in the 35% tax bracket and could have invested your money at 4%. If you earn 5% on your investment or savings, the breakeven period stretches out to 5 yr / 10 months.

I hope this helps you figure out the points / no points question. Have a great, Debt Free weekend.