Mortgage shoppers naturally want to lock in the lowest mortgage rates possible. However, the fees associated with your loan are an important reason why you shouldn't shop for a mortgage simply based on the lowest interest rate available.
How points affect your interest rate
The largest set of fees associated with any mortgage are what's known as points, which can -- and do -- affect the interest rate on your loan. If you're willing to pay what are known as "discount" or "origination" points, you can reduce or "buy down" your interest rate. On the flip side, there are also "rebate" or "negative" points. The way rebate points work is that if you can't or don't want to pay your closing costs out of pocket, you can take a higher-than-market interest rate that will substantially reduce or even zero out your closing costs.
"You can take a loan with no closing costs, but what you're asking is to finance those costs," says Justin Lopatin, vice president of mortgage lending at PERL Mortgage in Chicago. "You're taking a slightly higher rate, and you're paying the costs every month in that rate."
A point is an upfront fee equal to 1 percent of your loan amount. For example, if you borrow $200,000, one point is $2,000, half a point is $1,000 and a quarter point is $500.
As a general rule of thumb, a discount point paid today usually shaves no more than a quarter or eighth of a percentage point off your rate. The ratio isn't constant and changes with market conditions, interest rates and between lenders.
Pros and cons of paying points
There are several pros and cons to paying points. When market rates were higher than they are today, paying a point to lock in a lower rate often made sense. That's not the case today, however, because rates are near historic lows so the relationship between the cost of a point and the rate reduction doesn't pencil out, says Lopatin.
However, anytime you can pay less interest, you allow yourself the chance to qualify for a larger loan, build equity faster and can save thousands in interest over the life of the loan. But again, it all comes down to how much cash you have available or wish to spend on your mortgage.
Some people insist on paying points to get a lower rate even though it's less advantageous, says Gary Parkes, vice president of mortgage lending at Guaranteed Rate in Atlanta.
"If you really want that lower rate, we will give it to you, but it's going to cost you," he says. "It becomes psychological, not an economic or financial decision."
Points impact interest, equity and loan size
A little math illustrates the influence of points on your loan's interest, how quickly you build equity and the amount of money you can qualify to borrow.
Let's say you have been approved for a $200,000 mortgage at 3.50 percent with no points. For the sake of this example, we'll assume that one point will raise or lower your interest rate by 0.25 percent. You have three options:
- Pay one discount point in addition to your closing costs for a lower interest rate of 3.25 percent
- Pay no points at all, leaving your interest rate unchanged at 3.50 percent
- Receive one rebate point, $2,000 at closing, in exchange for an interest rate of 3.75 percent. Whether you wish to apply that $2,000 to your closing costs or not is your choice.
By paying the one point, your savings of improved equity and lower interest netted you $2,427 over a seven year period. Receiving the one rebate point cost you an additional $2,418 in interest and lost equity.
Paying points to get a lower interest rate can also allow you to borrow much more mortgage on the same amount of income. That larger loan size can be the difference between competing for a larger, more desirable home in a neighborhood with better schools. Using our interest rate examples above, you'll be able to borrow an additional $24,174 at 3.25 percent as opposed to 3.50 percent.
Paying points on an ARM
Paying a point on an ARM can have multiple benefits. For one, it lowers your monthly payment. But more importantly, it provides you some additional protection against any future period of high interest rates. This is because your "caps" (limits on interest rate changes) are based upon the loan's original interest rate.
Income tax implications
One factor that's often missed in the discussion is the income tax treatment of points, says Andrew Kalotay, president of Andrew Kalotay Associates, a New York-based research and analytics company.
HSH.com's mortgage calculator can help you plug in the different interest rates to see how paying points will affect your overall interest payments. Remember, the lowest rate mortgage may not be the lowest cost mortgage, so you should take the time to do the math to see how points impact your loan.
Again, each borrower's financial situation is different, so the decision to pay or not pay points comes down to the cash reserves you have available at closing.
Marcie Geffner is an award-winning freelance reporter, writer, editor and blogger whose work has been published by MSNBC, CNBC, Yahoo! Finance, Fox Business, Bankrate.com, AOL Real Estate, ThirdAge.com, Fidelity.com, Inman News and dozens of major U.S. newspapers. She holds a bachelor's degree in English from UCLA and MBA from Pepperdine University. You can follow Marcie on Twitter: @marciegeff.