Paying for points on a mortgage

Mortgage points graphicDid you know that mortgage points can lower your interest rate? It's true!

Here's how mortgage points work. The lender needs to earn a certain amount of interest on a loan. The lender could offer you a 5% interest rate on the loan amount of $100,000 for 30 years and you would pay $93,256 in interest over the life of the loan. Ouch!

But if you're willing (and able) to prepay some of the interest at settlement, the lender can offer you a lower interest rate since you are paying some of the interest upfront. Here's what I'm talking about. Below, is a typical interest rate chart that displays the interest rates for a 30 year mortgage. The interest rates are listed on the left column and across the top of the chart are the "lock in" days. That means the interest rate and points are guaranteed for either 15, 30, 45 or 60 days.

Mortgage points with interest rate

The borrower could receive a 4.25% interest rate with 2.133 points if the loan closes within 15 days. If the lender determines that 45 days is necessary to process the loan, 2.246 points are required to hold the 4.25% interest rate. The number of points increase with the lock in time period.

The closest zero point interest rate on this chart is 4.75%, but the points are listed as (.364). This means that the lender can pay 0.365% toward the borrower's closing costs with a 45 day lock. At 5.375% with a 45 day lock, the lender could pay back to the borrower 2.92% to the borrower.

Just to recap. As the interest rate increases, not only do the mortgage points decrease, but go negative. The number of mortgage points increases as the lock in period increases.

How much are mortgage points?

A mortgage point is equal to 1% of the loan amount. The math is simple. Multiply the loan amount by the mortgage points and hit the percentage key on your calculator. For example, $100,000 X 1% = $1,000.

Are points worth it?

Let's say you are borrowing $100,000 and the lender can offer you an interest rate of 4.75% for a 30 year term and no points, or 4.25% with 2.246 points. Which option is better?

At 4.75%, the principal & interest payment would be $522 and the total interest paid over 30 years would be $87,793.

At 4.25%. the principal and interest payment would be $492 and the total interest paid over 30 years would be $77,098.

The interest saved over 30 years is $10,695, but the upfront cost is $2,246.

As you can see, mortgage points can reduce the overall interest paid to the lender in this example, but are going to remain on the mortgage for a full 30 years? Are mortgage points worth the cost?

The mortgage points lowered the monthly payment by $30. If we divide the point cost of $2,246 by the monthly savings of $30, we arrive at 75 months. If you believe you are going to keep the mortgage for 6 1/4 years (75 months) or more, paying mortgage points are worth wild.