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Better To Pay ‘Points’ Or Take A Higher Rate?

September 27th, 2009 categories: Buying, Loans / Financing

One of the biggest dilemmas for many homebuyers in Benicia & Vallejo as well as throughout the rest of Solano County & the entire U.S. comes just about the time that their lender is ready to draw loan papers.Points-Int Rate Confusion

I’m talking about that really BIG decision that hits just about every home buyer at one point during the transaction.

No, not whether the furniture will really fit or whether their kids get to go to this school or that one.

No, I’m talking about that REALLY Big Decision — you know, the one where they have to decide whether to pay points and get a lower interest rate or forgo the points and take a higher interest rate with higher monthly payments.

Okay, maybe I’m exaggerating a bit. Maybe things like schools and furnishings really are a little more important to most buyers.

But when it comes to trying to decide whether to pay points and keep your payments low or save that money and pay a little more every month for the next 30 years, for many buyers, it can feel like the most important decision they’ve ever made.

Figuring It Out Is Easier Than You Might Think

In truth, though, it really should be a fairly easy decision, as long as you have a calculator handy.

Before I get into the details, let’s make sure you know what points really are and why they affect the interest rate.

Very simply, points are pre-paid interest. One “point” equals 1 percent of the loan amount. So if you have a $200,000 loan, 1 pt. is $2,000. Points are added to your closing costs. Essentially, you’re giving the lender an extra chunk of interest up-front in exchange for a lower interest rate over the life of the loan.

So why would the lender do that?

How Long Are You Really Going To Keep That Loan?

Well, for starters, they know that you’re probably not going to keep that loan for the entire 30 years. Most borrowers will likely move or refinance within about 5 years.

So if you pay a big chunk of interest up front and then retire the loan by the time they expect, the lender knows that even with a lower interest rate, they’ll come out just fine.

Plus, if you move or refinance earlier than expected, then they’ve pocketed all that pre-paid interest for a loan they get to take off their books extra-early.

Finally, rather than making money off you little by little every month, they get a big lump sum up front, which they can lend to another borrower and earn even more interest.

Okay, So Is it Better To Pay Points Or Take A Higher Rate?

So back to the question I posed in this post’s headline: Is it better for a borrower to pay points or take the higher interest rate?

In order to figure it out, you need to know the following:

  1. The monthly payments both With and Without points.
  2. How many points the lender will charge for the lower rate.
  3. Your anticipated loan amount.

Once you have those figures, simply calculate how long it will take before you’ll recoup the up-front costs and then decide a) if you’ll still be living there by that time; and if so, b) whether you’re likely to still have the loan by then.

Do The Math…

Here’s how to figure it out:

1. Subtract the lower monthly payment from the higher payment. This represents how much you’ll save each month with a lower interest rate.

2. Divide that figure into the amount you’ll pay for points. That tells you how many months before you’ll break even.

3. Look into the future and try to anticipate whether you’ll probably still have the loan by that time.

If the answer is ‘yes,’ you’ll be saving money from that point forward for as long as you keep that loan, which would probably make paying the points a good idea.

If the answer’s ‘no,’ then you’ll probably never realize any savings by paying the points, which means you should probably take the higher rate instead.

Take This Example…

Here’s a hypothetical example:

  • Loan Amount: $240,000
  • Points: $3,600 (1.5 Points)
  • Mtg Payment With 1.5 Points: $ 1, 270 (4.875% int rate)
  • Mtg  Payment With 0 Points: $1,325 (5.25 % int rate)

Here are the calculations:

1. The difference between the two payments is $55/mo. ($1,325-$1,270).

2. It will take 66 months (5.5 years) before you’d recoup the $3,600 you paid in points ($3,600 / $55 = 65.45 months).

So based on this example, ask yourself:

1. Am I probably going to be living in this house 6 years from now? No one knows what the future will bring with 100% certainty, but most of us probably have a pretty good idea where we’ll be 5-6 years from now.

2. Am I likely going to refinance this loan in order to get a lower interest rate or a better type of loan over the next 6 years? Since today’s interest rates are about the lowest they’ve been over the past 40 years, you probably wouldn’t expect to get a better loan/rate in the next 6 years. So in this case, the answer is probably ‘No.’

3. Am I likely going to want to refinance as the property appreciates in value and use some of the equity to remodel, improve, or even pay for things like college expenses, credit card debts, etc. If that’s likely going to happen before Year 6, then you’ll be paying off your loan before you reach the break-even point, which means you’d probably lose money by paying the points today.

Finally, Don’t Forget All That Lost Interest

The last thing to consider if you’re paying points is that you’ll also be losing the interest you otherwise would have earned on that money.

That may not be a huge consideration, but nevertheless, if you didn’t pay $3,600 in points and earned 1.5% a year in interest on that money instead, after five years, you’d have earned another $275. And it would really be another 5 months (or, just about six full years in all) before your monthly savings would equal what you paid up-front.

So when your lender is ready to draw loan papers and wants to know whether you want to pay points or not, instead of breaking out into a cold sweat, break out your calculator instead and do the math.

The answer should be as plain as day.

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This entry was posted on Sunday, September 27th, 2009 at 11:35 pm and is filed under Buying, Loans / Financing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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