Pay Points on an Adjustable Rate Mortgage (ARM)?
November 22, 1999, Revised August 27, 2010, Reviewed Feb 13, 2011

" 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 on an ARM, (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, you don't have to pay as much to reduce the rate on a 3-year ARM as you do on an ARM with a longer initial rate period, or a fixed-rate mortgage. In addition, paying points to reduce the starting rate usually gives you the benefit of a lower maximum rate as well.

Paying Points to Reduce the Rate Versus Paying Points to Reduce the Margin


This article is about paying points to reduce the start rate. Some mortgage lenders will allow borrowers to buy down the margin, which is the amount that is added to the rate index to determine the new rate when the rate is adjusted. The benefit from buying down the margin does not accrue until the first rate adjustment. On a 5/1 ARM, for example, buying down the rate results in  a lower rate for the first 5 years while buying down the margin results in a lower rate for the remaining 25 years. Lenders ordinarily do not quote prices for margin buy-downs and they are not considered further in this article

Points Required to Reduce the Rate by 0.5%


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

When I revised this article in 2010, I checked these numbers and found that the price of a 0.5% rate reduction had risen for all except the 3-year ARM and probably the one-year ARM but I had no reliable data on the one-year ARM in 2010. On the 5-year ARM, for example, the price rose from 1.25 points in 1999 to 2.46 points in 2010, which is almost twice as much. However, a harder look revealed that in every case, the big price increase occurred in going from a reduction of .375% to a reduction of .5%. On the 5-year ARM, the price of a .375% rate reduction was only 1.04 points, or less than half the price of a .5% reduction. I have no explanation for this.

Should You Pay Points to Reduce the Rate?


These number don't answer the question. To determine whether paying points makes sense for you, 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 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.

Balance Reduction: 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 to 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
Points Quoted by 13 Lenders to Reduce Rate Break-Even Period, in Months
Mortgage Type Decline in Rate Average Quote Lowest Quote Highest Quote Average
Purch /Refi
Lowest
Purch/Refi
Highest Purch/Refi
30-Yr FRM 0.5% 2.17 1.875 2.4 58/77 50/66 65/85
15-Year FRM 0.5 1.74 1.5 2 49/63 41/54 58/73
7/1 ARM 0.75 2.2 1.75 2.625 38/51 30/41 46/62
5/1 ARM 0.75 2.0 1.75 2.354 35/47 30/41 41/55
3/1 ARM 1.00 2.3 2 2.764 30/95 26/35 36/194
1/1 ARM 1.00 1.5 0.75 2.5 None 10/49 None


Note: Results are 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.
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