Points
on a Mortgage - Definitions and Simple Examples
This series of articles will try to help you understand the advantages and disadvantages
of points so that you will be a savvy borrower making an intelligent, informed
decision.
The first thing to understand is that points are a way of
choosing when
to pay the interest on your mortgage. Points are not a fee.
A positive point is paying the interest in advance at the closing instead of
over the length of the loan. A negative point is a way to add interest to the
mortgage in return for not paying some or all of the costs at the closing.
Points are the one advantage that a borrower has in their favor to control future
payments and save money on their mortgage both in the long term total and in
the short term of lower payments. Many, many borrowers miss this opportunity
to save money because they misunderstand the concept of points, or think that
some mortgage person is trying to get more money out of them.
Nobody is getting any extra out of you. You are going to pay this interest to
the bank at one time or another during the length of the loan. The decision
to be made is what makes the most financial sense for you.
Definition - What is a point?
One point is 1% of your mortgage. Two points is 2% of your mortgage amount and
so on.
A point is pre-paying interest on your mortgage.
A negative point is adding interest to your mortgage.
What do you get for paying points?
Paying points get you a lower interest rate.
Taking negative points gets you a higher interest rate in return for lower or
no costs at closing
The key to paying points is not to be average
This may sound strange at first, but you really don't want to be average in
order to take advantage of paying points on a mortgage.
When the bank determines just how low your interest will go when you pay a point,
they base this on the "average" length of time a borrower will keep
that mortgage. This is an important concept because all the bank really cares
about is that they make a profit on the total of all their mortgage loans and
that this profit "averages" to a certain amount on the total of all
the loans.
The bank doesn't really care whether they make enough on
your loan because
they know that on average they will make more money on somebody else and overall
they will make enough money to meet their goals.
There really are very few borrowers who are "average" yet many, many
borrowers do not pay points. This means that half of these people are giving
more money to the bank than they have to.
Your goal is to have a plan that makes sure that you are one of the borrowers
whose loan makes less than the average. You want to be one of the half that
gives less money to the bank than they have to. Let them make money on someone
else!!
Doesn't this make sense?
For example, Here are Joe and Julie Borrower, the average couple in the bank's
eyes. They will take a 30 year mortgage, pay no points, hold the mortgage for
exactly 5 years, have 1.8 cars and 2.1 kids.
Just joking on the kids and cars! But it makes the point, we all understand
that nobody has 1.8 cars or 2.1 kids. We know that this is average. Most
of us wouldn't try to be average when it comes to kids and cars. But for some
reason, when it comes to mortgages, more borrowers try to be average than is
necessary even though they know that they are not the perfect average.
Now, if an average mortgage is a 30 year fixed rate mortgage for 5 years, we
all understand that about half of the borrowers will keep this mortgage less
than 5 years and about half of the borrowers will keep the mortgage for more
than 5 years, right?
Being the one the bank makes less money on
Hopefully, I have your attention now and this idea of paying points, whether
positive or negative is starting to sound like something you should do.
The Goal of the bank is to
make an average amount of profit on each mortgage that they issue. Therefore,
on about half the borrowers, they will make less than the avearage and on about
half of the borrowers they will make more than the average..
Your goal should be to end up in the half of the borrowers that the bank makes
less on and the one sure way to do that is points.
If you will stay in the mortgage longer than average, then you will want to
pay points. If you stay in the home less than average, you will want to take
points, a concept I call negative points.
So, how can you be one of the smart and savvy half?
I will go into more depth in the rest of the series of articles on points, but
here are a couple of simple examples to give you an idea of how to do it right.
For simplicity sake we will use round numbers to give you a taste.
Example of the Average Borrower
First, let's look at the average borrower. For the average borrower, it really
makes no difference to pay points. The average 30 year loan is kept just 5 years
and the average borrower keeps that 30 year fixed loan exactly 5 years.
Now, let's say that the bank's average on a $200,000 loan at 6% is to collect
$12,000 of interest each year or $60,000 in five years.
Let's say the average borrower paid 2.5 points at closing, or $5,000, their
interest rate goes down and now they only pay $11,000 a year. The "average"
borrower now pays $55,000 in interest over the five and a half years.
By paying $5,000 up front, this borrower saves $1,000 a year on interest. Over
the five years, this borrower still pays $60,000 in interest and there is absolutely
no advantage to them to pay the money sooner rather than later. They end up
paying the same amount.
Example of Keeping a Loan Longer than Average
We know that very few borrowers will keep the home exactly 5 years.
Let's say that you are a borrower who keeps the loan for 10 years and pays the
$5,000 up front to save the same $1,000 a year of interest.
Over ten years that would be $10,000!! Your $5,000 just saved you an extra $5,000
by being the savvy borrower. Every additional year that you keep the home, you
will save another $1,000. The savings just keeps growing and growing the longer
you keep the home.
Now, on the other hand, if you pay the $5,000 and only keep the home 3 years
your $5,000 will only have saved you $3,000 and you are the borrower the bank
loves to have. You don't want to be this borrower! Let somebody else do this!
Example of Keeping the Loan Shorter than Average
So, now you're the borrower that keeps the loan for only 3 years. From the example
above, you don't want to pay points at all, right?
Nope! No points for you. You have a different choice and this is where the negative
points are an advantage to a borrower like you.
WIth negative points you pay a higher interest rate and the bank gives
you
money at the closing to pay the closing costs.
Using the same simple example as above, let's say that closing costs are $5,000
and if you take 2.5 negative points, the bank pays the $5,000 for you at the
closing. You pay an extra $1,000 a year in interest in return for the bank paying
the closing costs.
Again, after exactly 5 years you will have paid back $5,000 and it makes no
difference. The bank makes no more money than before, you have saved no money.
However, if you keep the house only 3 years, you will have only paid that extra
$1,000 3 times and you got the bank to pay $5,000 of closing costs and you paid
only $3,000 for them to do it!
Ah-ha! Got 'em again!
The Borrower who pays no points
Just to finish up on the simple examples, let's look at all the borrowers who
pay no points at all, whether positive or negative, they refuse to do it.
For the borrower who pays no points and keeps the house 10 years, they will
pay $1,000 a year more than the savvy borrower every year after the 5 year average
period. You don't want to be this borrower!
Now, for the borrower who keeps the loan just 3 years and refused to take the
negative points and just paid the $5,000 at closing, they will have saved $1,000
a year in interest but end up paying $2,000 more to the bank than the savvy
borrower. You don't want to be this borrower either!
So many borrowers today are so focused on the interest rate that they forget
that the goal is to pay the least amount of money. Who cares if your neighbor
got a lower interest rate is you paid less for your mortgage than they did,
right?
Summary
Points are probably the single most misunderstood concept in the mortgage industry.
Understanding the value of paying positive or negative points, depending on
your individual situation, can also be the single best way to save money on
your mortgage.
Borrowers that come to me all have a preset idea about what is the best way
to go. Usually they have read some general article somewhere about one of these
options. "Don't pay Points!" "Pay the Points!" "Zero-Cost
is the way to go!" In most cases, these were an answer to a particular
question for someone in a particular situation, but the borrower just remembers
the answer, not whether or not the question fit their
own situation.
As you can see from the simple examples above, it is really pretty easy to use
points to your advantage one way or the other. There are very few borrowers
who will not benefit from taking advantage of either paying points or taking
negative points.
If your mortgage professional has not given you some choices or helped you walk
through your own situation to see if there is a better way to do you rmortgage
and save money, you've got the wrong mortgage professional.
When you do business with myself, you will always hear the choices and you will
always know you got the very best deal you could when you get to the closing
table!
