The question is: Should I pay points to get a lower rate?
Understanding Mortgage Points and Lender Pricing
When shopping for a mortgage, terms like “point” and “points” might sound a bit confusing. Don’t worry—I’m here to break it all down and help you understand the mechanics of mortgage pricing, so you can make informed decisions about whether paying points to get a lower rate is right for you.
What Are Mortgage Points?
Mortgage points are fees paid upfront to lower your interest rate. One point equals 1% of your loan amount. For example, on a $200,000 loan, 1 point would cost $2,000.
Points can be a great way to save money over the long term if you plan to stay in your home for a while. Let’s revisit our earlier example to see how this works.
Simple Example: How Points Affect Payments
For a $100,000 loan:
– 6.5% Interest Rate (0 points): $632.07/month
– 6.25% Interest Rate (1 point): $615.72/month
– 6% Interest Rate (2 points): $599.55/month
Paying 1 point might save you $16.35/month, while 2 points saves $32.52/month. But when do you break even?
Understanding the Break-Even Point
The break-even point is the time it takes for your monthly savings to cover the upfront cost of the points. Take the cost of paying the point(s) divided by the savings to get the # of months it takes to break even.
For example: if paying 1 point on a $100,000 loan ($1,000) saves $16.35/month, then the math to determine the break-even point is = $1,000 ÷ $16.35 ≈ 61 months (just over 5 years).
If you’re planning to stay in your home longer than the break-even point, paying points could make financial sense.
The Role of Lender Margins and Market Pricing
When shopping for a mortgage, you’re likely focused on the interest rate and monthly payment. But behind the scenes, there’s a fascinating system at play that determines the rate and points a lender offers you. This process is rooted in how lenders price loans in the secondary market. The secondary market is where loans are bought and sold after they are originated. Organizations like Fannie Mae, Freddie Mac, and Ginnie Mae purchase these loans, package them into securities, and sell them to investors, ensuring lenders have funds to continue offering new loans.Let’s peel back the curtain and explore how it works.
For lenders that don’t hold loans in-house or in portfolio, mortgage pricing starts in the secondary market, where loans are sold to investors. Every lender has a profit margin, an amount they need to collect to cover their expenses and make a profit. This margin affects the points they charge. For illustrative purposes, let’s assume the lender’s needed margin is 1% of the loan balance as we delve deeper into how points work.
Par pricing is a key concept here.
At par, a lender can sell your loan for 100% of its face value—neither gaining nor losing money on the sale. However, for the lender to stay in business, they need to collect revenue to cover their expenses and earn a profit. That’s where points come in.
How Par Pricing Affects Points
Let’s break this down:
- If a loan is priced at par (100% of face value), the lender earns no additional revenue from the sale. To cover their margin (usually around 1%), they’ll need to charge you 1 point.
- If the rate on your loan is below par (e.g., 99%), the lender will need to charge additional points to offset the discount and cover their margin.
- If the rate is above par (e.g., 101%), the lender can offer you zero points or even a credit, as they’ll earn extra revenue from the sale.
How Rates and Pricing Work
Lenders quote rates to borrowers in increments of 1/8% (0.125%), but behind the scenes, loans are priced in finer increments, often down to 1/32% (.03125), This granularity allows for precise adjustments based on market conditions, loan characteristics, and the lender’s desired margin.
Simplified Explanations
It’s important to note that the examples I’ll cover are an oversimplification to demonstrate the concepts. The actual math behind pricing and points involves more variables, such as loan terms, credit scores, and market conditions. However, understanding the basic theory helps you see how lenders balance pricing and points to offer you the most competitive rates.
Example: Points Based on Lender Pricing in the Secondary Market
Imagine the following scenario:
- At 6.25%, the rate is par (100%)
- The lender charges 1 point to cover their margin.
- At 6%, the market price is 99%
- The lender charges 2 points:
- 1 point to bring the price back to par.
- 1 point to cover their margin.
- The lender charges 2 points:
- At 6.5%, the market price is 101%
- The lender charges 0 points, as the above-par pricing already covers their margin.
Why Does This Matter?
Understanding how lenders price loans helps demystify the trade-off between rates and points. If you’re offered a no-points loan, the rate may be higher because the lender earns their margin from the above-par pricing. Conversely, paying points lowers your rate but increases upfront costs.
When Does Paying Points Make Sense?
Here are some key factors to consider when deciding whether to pay points:
1. How Long You’ll Stay in the Home: If you plan to sell or refinance in a few years, paying points may not be worth it.
2. Your Budget: Can you comfortably afford the upfront cost of points?
3. Your Financial Goals: Are you aiming for lower monthly payments or minimizing upfront expenses?
Final Thoughts
Mortgage points and par pricing might sound complex, but with a little understanding, you can use them to your advantage. The decision to pay points is ultimately about finding the right balance for your financial situation and long-term goals.
That’s where I come in. With over 30 years of experience helping New Hampshire homeowners, I can break down the numbers and show you exactly how different options affect your budget, both now and in the future. Whether you’re buying your first home, refinancing, or planning for the long term, I’ll make sure you have the clarity and confidence to make the best decision for your unique situation.
Let’s get started! Call, text, or reach out online to me, Renee Duval — I’m here to help you every step of the way.