(This is Part 3 of a seven-part series. See Part 1: Mortgage shopping: what you should know before you begin; Part 2: Pros and cons of fixed, adjustable mortgages; Part 4: How long should you take to pay off your mortgage? Part 5: Investment returns influence real estate down payment; Part 6: Understanding choices in mortgage insurance and Part 7: Navigating real estate loan locks, docs.)
This is the third article of a series on the decisions mortgage borrowers should make prior to entering the market. Last week’s article was about selecting the best type of mortgage. This article is about three options that are available on most mortgages: whether to pay points, to waive escrows, and to accept a prepayment penalty.
Paying points: Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, two points is $2,000.
Points are traded off against the interest rate. For example, on Sept. 7, 2005, one lender offered 30-year fixed-rate mortgages (FRMs) at 6.25 percent with zero points, 5.875 percent with one point, and 6.875 percent with (-1.5) points.
Paying points is an investment. The return on investment is the smaller payment and more rapid amortization that result from the lower rate. The return is higher the longer you have the mortgage.
Suppose, for example, you pay one point to reduce the rate from 6.25 percent to 5.875 percent. Over three years, you earn 6.5 percent on your investment, rising to 17.6 percent over four years, 22.8 percent over five years, and 29 percent over 12 years or longer. I calculated these returns, as you can, using calculator 11c on my Web site. A companion calculator, 11d, does the same for adjustable-rate mortgages (ARMs).
Negative points or rebates are payments made by the lender to you for paying a higher rate. For example, the lender cited above will pay you 1.5 points for accepting 6.875 percent rather than 6.25 percent. You can use the payments to defray settlement costs. This may be attractive if you are cash-short.
Points that you receive for accepting a higher rate mortgage cost you more the longer you have the mortgage. Over two-and-a-half years, you will be paying 2.9 percent for this money, rising to 12.7 percent over three years and to 23 percent over four years.
I have calculated returns from similar schedules covering a number of lenders and different types of mortgages. I found that in most cases, paying points is a good investment if you hold the mortgage three years, but in a few cases you have to hold it for four years. This holds for both FRMs and for ARMs with initial rate periods of three years or longer. Negative points are very costly unless you are out within three years.
I also found that differences between lenders are large. This is why it is a good idea to know about how many points you want to pay (or receive) before you shop for a mortgage.
Since lenders quote rates in even increments of 0.125 percent and points to odd decimals, the way to shop is to find the rate which most loan providers quote with about the number of points you want to pay, then select the lowest points offered at that rate. For example, if you want to pay about two points and you find that A offers 6 percent with 2.13 points, B offers 6 percent with 1.97 points, and C offers 6 percent with 2.25 points, you would want to select B.
Waive Escrows: Lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments, which are placed in escrow until the payment date when the amount due is paid by the lender. I welcomed the arrangement when I had a mortgage, because it simplified our budgeting. It was a small price to pay, I felt, for giving up the interest on the escrow account to the lender.
Other borrowers feel differently, however, and want to control the payment of taxes and insurance themselves. This avoids the risk that the lender will screw it up, which happens occasionally and can be a nightmare for the borrower. If you feel this way, the lender will usually let you waive the escrow requirement if you are making a down payment of 20 percent or more, or if you make a modest payment, usually 1/4 of a point–that’s $250 for each $100,000 of loan amount.
Prepayment Penalty: A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Prepayment penalties usually decline or disappear with the passage of time, seldom applying after the fifth year.
Borrowers in the sub-prime market are required to accept penalties, but for other borrowers it is an option that can be exercised to reduce the rate. If you are taking an FRM, have a long time horizon, and would prefer not to be bothered refinancing if interest rates go down, you are the perfect candidate to exchange a prepayment penalty for a lower rate.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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