Mortgage

How do mortgage points work?

Your ability to understand loan points can save your clients thousands of dollars

Shopping for a mortgage can be overwhelming and sometimes utterly confusing. Points, no points, closing costs, rebate credit — the options seem endless. Trying to compare rates from one lender to another? It’s not as easy as it sounds. Rates change daily, so unless you are getting updated quotes from all lender options on the same day, you’re not comparing apples to apples.

You see, comparing mortgage lenders is kind of like driving down the road trying to find a gas station. Today, BP might be 1 cent cheaper than the Shell station across the street. Tomorrow, the Shell station might drop its price to meet a sales quota and take the most competitive spot.

For the most part, mortgage companies offer the same products as one another, with the same guidelines. Conventional loans are underwritten to Fannie and Freddie’s requirements, Federal Housing Administration loans to Ginnie’s, and VA loans to the standards of the Department of Veterans Affairs. It should be easy to compare price, right?

Wrong.

To start with, it is essential to understand how rebate credit and discount points work. You will use this knowledge combined with an estimate of how long you will keep this mortgage to help make an educated decision on how to structure a loan. You will also need to be able to tell the difference between a lender specific fee from a third party real estate fee.

For example, let’s take an imaginary homebuyer named Ted. Ted is buying his first home for $250,000 and is putting 20 percent down. His mortgage amount will be $200,000, and he wants a 30-year fixed-rate loan. Ted just got married and plans to have children in the next few years. He expects to sell this house in the next five years, and then buy a larger home when his family grows.

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Ted has obtained the following quotes from three different lenders:

1. 4 percent fixed with 0 points; $955 monthly payment

2. 3.75 percent fixed with 1 point; $926 monthly payment

3. 4.375 percent fixed with -2 points of rebate credit; $998 monthly payment

Let’s dig into the numbers a little bit to figure out which option is in Ted’s best interest.

A zero-points loan does not mean Ted will not pay any closing costs. It just means he is not buying the rate down. A zero-points loan is a loan priced at the lender’s market or par rate. If Ted takes the zero-points loan, his monthly payment will be $955.

In the next instance, 1 point is equal to a fee of 1 percent of the loan amount. So for the second option, Ted would pay an extra $2,000 (1 percent of $200,000) compared to option one at par to obtain a lower-than-market rate of 3.75 percent. If he does this, his monthly payment will be $926.

Rebate credit is the opposite of paying points. At -2 points of rebate credit means the lender is offering up to 2 percent of the $200,000 loan amount ($4,000) at closing to offset Ted’s closing costs. In exchange, Ted would have a higher-than-market rate. If Ted goes with option three, his monthly payment would be $998. However, his closing costs would be $4,000 less.

So what should Ted do?

If Ted pays 1 point to buy the rate down to 3.75 percent, his monthly payment would be $29 less than the zero-points loan, but his closing costs would be $2,000 higher. If you divide $29 into $2,000, you’ll see it would take him 68.96 months (5.74 years) to get his upfront cost back because he’d save only $29 each month on his payment. If he sells his house or refinances in less than 5.74 years, he would lose money paying 1 point to take a 3.75 percent interest rate.

If Ted takes the -2 points of rebate credit and accepts a higher-than-market rate of 4.375 percent, his payment would be $43 higher than the zero-points loan. His closing costs would be $4,000 less. If you divide $43 into $4,000, you’ll see it would take him 93 months (7.75 years) for the higher-rate loan to cost him more money than the zero-points loan. If he sells his house in five years, the higher rate would have cost him $2,580 in additional interest, but since he received $4,000 upfront via rebate credit, he would actually walk away with a $1,420 profit. So in this hypothetical example, the higher rate makes the most sense for the borrower.

Now that you know understand the basics of how mortgage points and rebate credit work, you need to be able to compare closing costs from one lender to another. Ask your lender to break down exactly what fees his or her institution charges to make the loan. Exclude prepaid items such as homeowners insurance, property taxes, title charges, recording fees, prepaid interest and attorney fees. These fees will cost you the same regardless of the lender you select.

Now you can compare apples to apples.

Tony Davis is a senior loan officer in Atlanta, Georgia. He specializes in providing purchase and refinance mortgages to homebuyers and existing homeowners, and serves as a consultant for real estate agents.

Email Tony Davis.