Points refer to upfront cash payments that lenders require from a borrower as part of the costs of accepting the loan. It is usually expressed as a percentage of the loan amount.
For example, 2 points refers to 2% of the loan amount.
Sometimes when points are paid on a loan by a lender when the rate is above the zero point loan rate. This is described as negative points.
In situations where negative points occur, the lender credit the borrower. Or when a mortgage broker is involved in the transaction, the broker is credited.
In practice, points may also be referred as rebates or discount points. And when brokers retain them, the term yield spread premiums is used.
Points and rebates system
As consumers have accepted that points are part and parcel of dealing with lenders, it is no longer enough to look at interest rates when seeking out home loans.
A borrower needs to look at interest rates and points of a loan package.
For example, a lender might have the following loans available on a fixed rate mortgage:
- 5% and 2 points
- 6% and 1.5 points
- 7% and 1 points
As can be observed, the higher the interest rates, the lower points.
This makes sense as the more interest a borrower is willing to pay, the more a lender would be willing to compromise points.
This system gives borrowers more options and flexibility in choices.
If a home buyer has every intention to stay in the house for a long time, and keep the mortgage along with it, then paying more points in exchange for a lower interest rates will be more worthwhile in the long run due to the accumulated interest savings.
Home buyers who are unable to qualify for the loan they require to close a deal may even pay points to reduce their monthly payment, thus increasing the approved loan quantum.
On the other side of the coin, if a borrower has a short time horizon, paying as little points as possible can be more beneficial. Because even though they might incur higher interest rates, they are not going to be on it for very long.
Moreover, home buyers who are short on cash (which are getting more common these days) could choose to pay higher interest in exchange for higher rebates which can be used to offset their settlement costs.
If a borrower’s decision is not going to be influenced by their personal financial circumstances, meaning they are not cash short or cash long, then it might be wise to plot a graph to detail the charges over the loan period.
This is to compare between a high-rate/low-points combination with a low-rate/high-points combination.
If this is done correctly, you will be able to pinpoint the exact moment when the break even point is reached.
More points vs more down payment
As previously described, borrowers with cash on hand might see paying more points as a shrewder move as it helps him save on interest rates over the long run.
But if that’s the case, why not use that money to pay a larger down payment upfront?
This would help save on interest cost over the long term too.
The difference between the two is that a higher points option helps the borrower save on interest rates resulting in a lower annual percentage rate, while going with higher down payment results in lower interest costs due to a lower principal.
Keep in mind that there might be other indirect cost savings associated with a smaller loan amount. For example insurance premiums and redemption fees.
Both methods are going to help a borrower money.
The one that yields the most savings over the life of the mortgage will be the winner.
This means that how long the borrower estimates the loan will be kept becomes a critical factor.
Generally speaking, the longer the time horizon the more attractive a higher points payment is. And the shorter the time horizon the better a bigger down payment looks.
From data research and observation, the point where both options intersects, which means that their benefits are the same, is around 8 years give or take.
This implies that if a borrower’s time horizon is greater than 8 years, it can be considered a long term vision. While one shorter than 8 years is a short time horizon.
Since we are on the topic of breakeven points, let’s also touch on how points can also be included in the loan amount.
This is called financing points.
When this is structured into a loan, the breakeven point tend to be extended to a later period if the savings rate is below the high-rate/low-points mortgage combination.
Moreover, in a real estate transaction, tax deductions are spread out over time when there are financing points. Making it less attractive to an investor.
In contrast, points paid in cash are tax deductible in the current financial year.
All in all, financing points are only worthwhile when the tax rate is low and savings rate is higher than the mortgage rate.