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16 February 2004, Revised February
22, 2005
What are points?
Points are an upfront charge by the
lender that is part of the price of a mortgage. Points are expressed as a
percent of the loan amount, with 3 points being 3%. On a $100,000 loan, 3 points
means a cash payment of $3,000. Points are part of the cost of credit to the
borrower.
Points can be negative, in which
case they are "rebates" from the lender to the borrower. Rebates can
be used by borrowers to defray other settlement costs.
Low rates come with positive points,
high rates come with rebates. Lenders offer borrowers a range of interest
rate/point combinations, leaving it to borrowers to select the combinations best
suited to their needs.
How should borrowers make the
decision to pay points or not?
Low rate/high point loans are for
borrowers who can meet the cash requirement, and either have a long time horizon
or want to reduce their monthly mortgage payment. High rate/low point
combinations are for borrowers who don't expect to be in their house very long,
or who are short of cash.
Can points be financed?
Yes, but it reduces the benefit to
the borrower unless the borrower is in a low tax bracket and can earn a high
return on his cash. You should never finance points if it pushes the loan amount
up to a level that triggers a larger mortgage insurance premium.
Are points tax-deductible?
On a purchase transaction, points
paid in cash are fully deductible in the year the loan is closed. If
the points are financed, they remain deductible if the cash contribution by the
borrower for down payment and other costs exceeds the points. On a
refinance, points paid in cash are deductible but the deduction must be spread
evenly over the term. If the loan is paid off, the unused portion can be taken
in the payoff year.
If points are financed, they are not
deductible as points but they increase the interest deduction. Interest is
deducted over the life of the loan, and if the loan is repaid early, the
unused deduction is lost.
How many points must I pay to reduce
the interest rate by �%?
Starting with the base interest
rate, which is the rate closest to zero points, expect to pay about 1.5 points
on a 30-year fixed-rate mortgage. For example, if the lender quotes 6% at zero
points and you want to reduce the rate to 5.75%, it will cost about 1.5 points.
To reduce the rate by .375%, .5% or .625%, expect to pay about 2.125, 2.75 and
3.25 points, respectively.
Similarly, the following rate
increases are required to produce the indicated rebates: .125%/.625 points;
.25%/1.125 points; .375%/1.625 points; .5%/2.125 points; .625%/2.625 points; and
.75%/3 points. For example, if you want a rebate of 2.125 points, expect to pay
a rate about .5% higher.
On 15-year loans, all the points
shown above would be about .375 points lower.
These numbers are averages based on
recent price sheets of 10 lenders, and they are anything but firm. The amount of
variability from lender to lender is surprisingly large. For example, while the
average price to reduce the rate by .25% was about 1.5 points, two lenders
charged only 1 point and one lender asked for 1.875 points. Similarly, while the
average rebate obtainable for a .375% rate increase was about 1.625 points, one
lender offered 2.112 points while another offered only 1 point.
How should points affect the way I
shop for a mortgage?
Before you shop, decide what you
want to do about points. If you want to pay points to reduce the rate, you shop
rate based on a specified number of points. This has the added advantage of
letting loan officers know that you know what you are doing.
If you want a rebate, the best
strategy is to shop rate on a no-cost loan, which means a rebate high enough to
cover all settlement costs except escrows and interim interest. This has the
added advantage of protecting you against getting whacked with additional
settlement costs at closing.
Selecting a loan provider while the
rate/point combination is undecided is a bad mistake. Because of the wide
variability in pricing points, the lender offering the lowest points at one rate
is not necessarily the same as the lender offering the lowest points at a
different rate.
Furthermore, once you are too far
along in the process to back out, the price in points to lower the rate, or the
price in rate to increase the rebate, may be "off the sheet". Meaning
that the loan officer may take advantage of the opportunity to make a few extra
dollars by giving you a worse deal than the one shown on his price sheet.
Don�t let this happen to you.
Copyright Jack Guttentag 2005
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