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November 22, 1999
" I understand that if I
intend to stay in my house a long time, it may pay me to pay extra points to
reduce the interest rate, but does this apply to ARMs?� Does the interest rate
reduction on an ARM only apply to the starting rate, or does it carry through to
all the years?"
When you pay
additional points (each point is 1% of the loan amount), your rate reduction
applies to the start rate only. If the start rate holds for three years, the
rate reduction applies only for those three years. However, paying points to
reduce the starting rate usually gives you the benefit of a lower maximum rate
as well.
A survey I conducted on November 8, 1999
shows that the shorter the start rate period, the less you pay for a rate
reduction.
I "shopped" for a $200,000
30-year loan with a 30-day lock period among 13 national lenders offering loans
in California. For each ARM, I first noted the start rate with zero points, and
then asked for the points each lender charged to reduce that rate by 0.5%. Using
the prices quoted most often, here are the points charged to reduce the start
rate by 0.5%:
One-year ARM: 0.5
3-year ARM: 1.0
5-year ARM: 1.25
7-year ARM: 1.5
15-year FRM: 1.75
30-year FRM: 2.25
But these number don't answer the
question, which if any of these deals is best for you? To answer that, you must
know how long you plan to keep your mortgage, and you must know the
"break-even month", beyond which the savings from the lower rate
exceed the costs of the additional points.
Break-even calculators on my web site
for FRMs and ARMs answer this question by comparing the cost of the points with
the savings from the lower interest rate. [To use the calculators, click on The
Break-Even Period For Paying Points on Fixed-Rate Mortgages or The
Break-Even Period for Paying Points on Adjustable-Rate Mortgages].
The calculators figure in:
Tax savings:
Interest payments made in a given year are deductible in that year. On a
purchase transaction, points are deductible in the year of purchase but on a
refinancing, points must be deducted over the life of the loan.
Equity growth:
The higher the interest rate, the longer it takes to pay down the balance
and the slower the equity growth.
Lost interest earnings:
You could earn interest on the money you use to pay points and make monthly
mortgage payments
The break-even calculators reveal some
interesting patterns. With purchase transactions, unless borrowers expect to be
out of their house within 4 years, it usually pays to pay points to reduce the
rate on 7-year, 5-year and 3-year ARMs. Using the average prices charged by the
13 lenders, and assuming borrowers are in the 28% tax bracket, breakeven periods
were only 38 months for a 7-year ARM, 35 months for a 5-year ARM, and 30 months
for a 3-year ARM.
Using the same assumptions, the
break-even period for a 30-year FRM was 58 months, and for a 15-year FRM it was
49 months.
As an added bonus, when you pay points
to reduce the
start rate on an ARM, you usually reduce the maximum allowable rate over the
life of the ARM. In most cases, lenders set the maximum rate at a fixed spread
over the initial rate. This reduces the risk to the borrower in the event of a
future rate explosion.
But one-year ARMs are a different story.
In most cases, it does not pay to pay points to reduce the start rate on a one
year ARM, no matter how long you intend to hold the mortgage. Using the average
price among 13 lenders and the same assumptions as for the longer ARMs, you never
break-even. If you need a one-year ARM to qualify, the safest course is to
take the lowest rate you need to qualify, but no lower.
On refinance transactions, break-even
periods are uniformly longer than on purchase transactions because points must
be deducted over the life of the loan. On 7-year ARMs, for example, assuming a
28% tax bracket, the break-even period is 16 months longer on a refinance than
on a purchase transaction, while on a 5-year ARM it is 11 months longer.
Break-Even Period For
Paying Points to Reduce the Interest Rate by Varying Amounts, by Type of
Mortgage
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Points Quoted by 13
Lenders to Reduce Rate
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Break-Even Period, in
Months
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Mortgage Type
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Decline in Rate
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Average
Quote
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Lowest Quote
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Highest Quote
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Average
Purch /Refi
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Lowest Purch/
Refi
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Highest Purch/
Refi
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30-Yr FRM
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0.5%
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2.17
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1.875
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2.4
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58/77
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50/66
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65/85
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15-Year FRM
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0.5
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1.74
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1.5
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2
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49/63
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41/54
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58/73
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7/1 ARM
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0.75
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2.2
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1.75
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2.625
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38/51
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30/41
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46/62
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5/1 ARM
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0.75
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2.0
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1.75
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2.354
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35/47
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30/41
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41/55
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3/1 ARM
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1.00
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2.3
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2
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2.764
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30/95
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26/35
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36/194
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1/1 ARM
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1.00
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1.5
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0.75
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2.5
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None
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10/49
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None
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Based on rates and points on conforming
30-year home loans in California with 30-day rate lock and 20% down payment, as
of November 9, 1999. Break-even is calculated using a 28% tax rate and a 5%
reinvestment rate.
Copyright Jack Guttentag
2002
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