Should you pay points to lower the mortgage rate?

March 29, 2011 – If someone asks you what’s the better deal when purchasing a home—a 30-year fixed rate mortgage at 4.5 percent interest plus three points, or one at 5.5 percent interest plus one point—what would you say?

Just as in choosing the right mortgage product, the answer depends on how long you expect to stay in the property. If you’re only planning a short stay, you should probably pay as less points as possible because it may take several years (at least 5 or more) to break even.

Comparing prices of different mortgages can, however, be complicated. In addition to the interest rate, lenders may charge for discount points, origination fees, the appraisal, title and credit reports, and other miscellaneous items.

Points and Fees
Discount points and origination fees (referred to as points) are usually the largest fees lenders charge, so they make the most difference in determining which scenario is better. For this comparison, don’t worry about the other miscellaneous fees, such as the appraisal, title and credit reports. These charges are much less significant than points. Each point paid equals 1 percent of the loan amount, so if $100,000 is borrowed and you have to pay three points, you are actually getting $97,000. However, you have to repay $100,000, and have to pay interest on $100,000. The reason lenders charge discount points is to change the interest rate that is paid. The more points, the lower the rate, and vice versa. It can make sense to pay points. Here’s why:

APR
The real interest rate may also be called the effective interest rate but it is most often referred to as the annual percentage rate (APR). The APR is the rate for loans that are paid over a full term. For a 30-year loan at 4.5 percent plus the three points paid over a full 30-year term, the effective interest rate, or APR is 5.00 percent.

After applying for a loan to purchase your home, the federal truth-in-lending law requires lenders to disclose the loan’s APR within three business days for such purchases. You need a computer or financial function calculator to determine the APR precisely, but the following formula is a fairly accurate way of estimating it for comparison-shopping:

The number of points divided by 6 + the quoted Rate = APR

Now getting back to the question, which is better? Using the formula above, you’ll see the first choice is better.

#1: 3 points divided by 6 + 4.5 percent = 5.00 APR
#2: 1 point divided by 6 + 5.5 percent = 5.67 APR

It may not seem like a big difference in percentage, but it can add up to a substantial amount you will pay over the life of your loan. With this simple formula, now you can feel more comfortable in determining which mortgage pricing is best for you.

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