Low interest rates are a powerful incentive for borrowers to buy a home or refinance an existing mortgage. But when borrowers shop for a loan, the lowest rate shouldn't be the sole factor in their decision.
What really matters, says Julie Miller, a sales manager at Prospect Mortgage in Irvine, Calif., is the right combination of a low rate, affordable fees and what's known in the industry as "points."
"Borrowers," Miller says, "have to look at not only the interest rate but the overall cost of acquiring the loan."
Par Rate or Points
A point is an upfront fee that, by convention, is equal to 1% of the loan amount. For example, one point on a $150,000 loan would be $1,500, while two points on a $300,000 loan would be $6,000.
The interest rate associated with zero points is referred to as the lender's "par" rate, says Peter Thompson, a senior loan officer at Prospect Mortgage in Naperville, Ill. Borrowers who pay points at closing or who finance points as part of their loan amount should get an interest rate that's lower than par. Borrowers who take "negative" points, in the form of a credit toward their closing costs, agree to accept an interest rate that's higher than par.
"The par rate is the best rate (the borrower) can have without paying points," Thompson says. "If they want a lower rate, they would pay a point, and if they want some of their closing costs paid, we can do that by giving them a slightly higher rate."
Points also can be deducted for federal income tax purposes in some circumstances.
So should borrowers pay points? The answer depends largely on the borrower's individual situation, but these days most people are inclined to save their money upfront.
"Most people aren't paying any points," Miller says. "With interest rates as low as they are, it's more beneficial for someone to take the slightly higher rate to offset the closing costs."
Jay Dacey, a mortgage broker at Metropolitan Financial Mortgage Co. in Minneapolis, concurs.
"Given the opportunity to compare the three (options), people typically take the option with the negative points where they have their closing costs paid for them by the bank with a slightly higher interest rate," he says. "They like not having (to pay) the closing costs."
Another reason paying points might not make sense is that points aren't worth what they used to be. Not long ago, one point usually bought an interest rate reduction of a quarter of a percentage point. Now, however, a point might buy down the rate only an eighth of a percentage point, experts say.
"When we look at the reduction in the payment between paying a point versus not paying a point, the difference is minimal," Miller says. "The immediate benefit of holding onto cash is much more important."
Dacey says the par rate is so low today -- autumn 2011 -- that the lender doesn't give the borrower the option of paying discount points to lower the rate further.
Paying points to get a lower rate is a strategy that tends to appeal to established homeowners who plan to keep their loans until they're paid off, Thompson says.
One way to analyze the benefit of points is to calculate the payback period, Thompson says. Also called the break-even period, it's a measurement of how long it will take for the accumulated monthly savings to add up to the upfront cost of paying the points.
|Par loan||Discounted loan|
|Discount points paid||$0||$2,000|
In the above example, the borrower pays $2,000 upfront in the form of one discount point to save $15 a month. At that rate, the payback period is 11 years, 2 months. ($2,000 divided by $15 a month equals 133.3 months.)
A borrower who plans to move or refinance within 10 years wouldn't benefit from paying a discount point in that scenario because it takes more than 11 years of monthly savings to make up for the $2,000 upfront cost.
Dacey says paying points can make sense for homeowners who plan to live in the house far past the break-even date.
One other tip from Dacey is that loan pricing has become much more sensitive to credit scoring, which means late or missed payments on credit cards, auto loans and the like will trigger a significantly higher rate and closing costs for a mortgage, regardless of whether the borrower pays points.
The bottom line is that borrowers should do the math and not ignore the effect of points in their quest for the lowest possible rate on their loan.