Tutorial on Selecting a Rate/Point Combination

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18 April 2006

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, 2 points means a payment of $2,000. If points are negative, it is called a “rebate”, which the lender pays.

Points are traded off against the interest rate. For example, I took the following schedule for 30-year FRMs from www.countrywide.com on September 7, 2005.

Interest Rate	Points
5.125	3.75
5.25	3.25
5.375	2.75
5.5	2.375
5.625	1.875
5.75	1.375
5.875	1.00
6	0.625
6.125	0.375
6.25	0.0
6.375	-0.375
6.5	-0.50
6.625	-0.875
6.75	-1.25
6.875	-1.5

Paying points is an investment. The return is the lower payment and faster balance reduction that results from the lower rate. The return is higher the longer you have the mortgage.

Assuming you were choosing from the schedule above and elected to pay 1 point to reduce the rate from 6.25% to 5.875%. If you have the mortgage 3 years you earn 6.5% on your investment. The return rises to 17.6 % over 4 years, to 22.8% over 5 years, and to 29% over 12 years or longer. I calculated these returns, as you can, using calculator 11c. A companion calculator, 11d, does the same for ARMs.

Negative points are payments made by the lender to you for paying a higher rate. For example, the lender shown above will pay you 1.5 points for accepting a 6.875% rate rather than 6.25%. You can use the payments to defray settlement costs.

Where points that you pay yield a higher return the longer you have the mortgage, points that you receive cost you more the longer you have the mortgage. In the example above, you will be paying 2.9% for the 1.5 point rebate over 2.5 years, 12.7% over 3 years, and 23.0% over 4 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 3 years, but in a few cases you have to hold it for 4 years. This holds for both FRMs and for ARMs with initial rate periods of 3 years or longer. Negative points are very costly unless you are out within 3 years.

I also found that differences between lenders are large. One lender offered better deals buying down the rate on a 15-year FRM than on a 30, while another lender offered a better deal on a 30. This is why it is a good idea to know exactly how many points you want to pay (or receive) before you shop for a mortgage.

Since lenders quote rates in even increments of .125% 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 2 points and you find that A offers 6% with 2.13 points, B offers 6% with 1.97 points, you select B.