This tutorial explains the circumstances under which it pays borrowers to pay points to reduce the rate, and the circumstances under which it makes sense for them to pay a higher rate to obtain a point rebate from the lender.

Tutorial on Selecting a Rate/Point Combination
18 April 2006, Revised November 15, 2008, August 19, 2011

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. For background information about points, see Questions About Points.

Points Are Traded Off Against the Interest Rate

For example, I took the following schedule for 30-year fixed-rate mortgages (FRMs) from a lender's price sheet on November 14, 2008.

 Interest Rate Points
 5.375%  2.83
 5.5  2.20
 5.625  1.72
 5.75  1.00
 5.875  0.37
6  0.00
 6.125  -0.42
 6.25  -0.60
 6.375  -0.76
6.625   -1.18

Paying Points Is An Investment.

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

Assume you were choosing from the schedule above and elected to pay 1 point to reduce the rate from 6% to 5.75%. If you have the mortgage 4 years or less, you earn nothing (or less then nothing) on your investment. Over 5 years, however, you earn 7.45% and over 10 years you earn 17.56%. I calculated these returns, as you can, using calculator 11c Mortgage Points Calculator: Rate of Return on FRMs. A companion calculator, 11d, Mortgage Points Calculator: Rate of Return on ARMs, 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 1.18 points for accepting a 6.625% rate rather than 6%. You can only 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 the lender 5% for the 1.18 point rebate over 2 years, 27% over 3 years, and 42% over 10 years.

I have calculated returns from similar schedules covering a number of lenders and different types of mortgages. In general, paying points is a good investment if you hold the mortgage 4 years or longer, whereas negative points are very costly unless you are out within 2 years. Adjustable rate mortgages generally provide a higher rate of return on points than FRMs. See Is It True That Paying Mortgage Points Doesn't Pay?

Alternative Rate/Point Shopping Strategies

Know the Mortgage Type First: Don't even think of shopping for rate/points until you have decided on the type of mortgage you want. The lender offering the best deal on a 15-year FRM may not be offering the best deal on a 5/1 ARM.

Don't Ignore Fixed-Dollar Fees: In addition to points, which vary with the loan amount, lenders charge fixed-dollar fees -- they are the same regardless of loan size. Because they can vary from lender to lender, they need to be taken into account in shopping for the best deal.

Establish Your Rate/Point Profile: Before you shop for a mortgage, decide what your rate/points needs are using the following table, which is discussed in Why Many Borrowers Select the Wrong Combination of Interest Rate and Points. 


Borrower Is Income Short

Borrower Is Cash Short

Borrower Expects to Have Mortgage 4 Years or Longer

1. Select High Fees, Low Rate

2. Select Rate at Zero Fees

Borrower Expects to Have Mortgage Less Than 4 Years

  3. Select Rate at Zero Fees

4. Select Negative Fees, High Rate

Shop For Lowest Rate on a No-Cost Mortgage: Borrowers in cell 4, and perhaps in cell 3, should consider shopping for the lowest rate on a no-cost mortgage. This is a mortgage carrying a rebate high enough to cover all settlement costs except escrows and interim interest. This has the great advantage of simplicity -- you need shop only for rate. It has the added advantage of protecting you against getting whacked with additional settlement costs at closing. See No-Cost Mortgages.

Shop For Lowest Loan Fees at a Specified Rate: Borrowers in cell 4, and perhaps in cell 3, should select a relatively low rate that requires the payment of points, and use it as their "shopping rate." They shop for the lowest total fees (points plus fixed-dollar fees) at that rate.

Shop For the Rate/Fee Combination That Has the Lowest Total Cost Over the Borrower's Time Horizon: This is the best strategy of all, but it requires technology that is not yet available to borrowers. The technology will be a part of the professor's loan network that will become available later this year.

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