- Introduction
- Understanding "Points"
- Fixed-Rate or Adjustable-Rate Mortgages?
- Fixed-Rate Mortgages
- Adjustable-Rate Mortgages (ARMs)
Let's begin by looking at something you always hear about when you talk about mortgage basics: points.
Lenders make money on mortgage loans in two ways: (1) by charging you interest, which you pay each month when you send in your payment, and (2) by charging you a "loan fee," commonly called points, which are paid when you take out the mortgage loan.
Some loans are "no-point" loans, which mean that no money is collected up front. While this helps you with the cash that you need when buying the home, the trade-off is that the amount of interest you pay each month will be higher. There are also some unique tax treatments in conjunction with points paid on a refinance as opposed to points paid on obtaining an original loan. Sounds simple enough, but what does it mean to you? How do you choose between two different loans and decide which loan is cheaper for you?
One easy measure is to compare each loan's annual percentage rate (APR). Each lender is required by law to provide you with this information. When trying to decide between two loans, generally the one with the lower APR will be the cheapest.
The problem is that the APR is computed as if you held the mortgage until you completely paid it off. What if you only intend to stay in this home or keep the mortgage for five or six years? You'll need to look at the effective annual interest rate.
Rate versus Point Comparison
Here is an example of the rate versus point comparison. The loan with the lower effective rate wins.
Example |
Lower Rate and Higher Points |
Higher Rate and Lower Points |
a) Interest Rate |
4% |
4.125% |
b) Number of years you plan to hold the loan |
5 years |
5 years |
c) Multiply (a) by (b) |
20% |
20.625% |
d) Points |
2% |
1% |
e) Add lines (c) and (d) |
22% |
21.625% |
f) Divide line (e) by (b) to estimate the Effective Annual Interest Rate |
4.4% |
4.325% |
The effective annual interest rate represents the true annual cost of the loan over the period of time you intend to keep the loan. The lower the rate, the lower the cost of the loan. The effect of paying more points will diminish the longer you intend to hold the loan. Although this calculation will help you determine your best choice, it does not take into consideration the time value of money. If the time value of money is factored in, the effective annual interest rate would rise slightly as you pay more points.
IMPORTANT NOTE: Points paid on a mortgage for the purchase of one's principal residence are tax-deductible in the year they are paid. Points paid on a mortgage for the purchase of other real estate are deductible over the term of the loan.
SUGGESTION: Assuming equivalent APR's on two mortgages, one with points and one without, the rule of thumb is that the no point mortgage will be cheaper unless you plan on holding your mortgage loan at least nine or ten years.
SUGGESTION: Mortgage lenders are in a position to help explain the various features and benefits of the lending programs they offer. Don't be afraid to ask for help in understanding the many options.