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
cash payment of $2,000). The more points you pay, the lower the interest rate.
Paying points can be viewed as an investment that yields a return that rises
the longer you stay in your house. The return consists of the saving in monthly
payment resulting from the lower interest rate, plus the lower loan balance
in the month the loan is paid in full. This return can be compared to the
return on other investments available to you over a similar time horizon.
As an example, a 15-year fixed-rate mortgage was being offered in the market
at 6.375% and 0 points, and 5.875% with 2 points. On a $100,000 loan the investment
in points is thus $2,000.
The lower rate reduces the monthly payment by $27.48, and also results in
a faster reduction in the loan balance.
Over 3 years, the reduction in the payment and the balance don't cover the
$2,000 investment but over 5 years it yields a return of 5.1%, over 7 years
the return is 11.0%, and if the loan runs to term the return is 14.6%.
Here are some general rules to follow based on the market conditions in
early 2002
- Over a 3-year horizon,
paying points is a loser on any type of mortgage.
- Over a 5-year horizon,
paying points is a good investment on 5 and 7-year balloon mortgages, yielding
a return in excess of 15%, but only a mediocre investment on 15-year and
30-year mortgages.
- Over a 10-year horizon
(or longer), paying points will yield in excess of 15% on 15-year and 30-year
mortgages.
In the long term, an investment
in points on a 30-year fixed rate mortgage yields a return almost three times
that on a long-term government bond.
While market conditions can change, there is every reason to believe that
these high returns on investment in points will continue.
The returns reflect the high price investors in mortgages are willing to pay
for protection against "prepayment risk" ?the risk that when interest rates
fall, borrowers with fixed rate loans will refinance them at the new lower
rates.
High-point/low-rate loans carry less risk of future refinancing and are
therefore better priced.
Zero Cost or low-point/high rate loans carry more risk and therefore carry
the worst pricing. See zero cost loans or negative
points.
You must expect some down side to the high return on investment in points.
If you have to move unexpectedly, the return is reduced. In addition, you
give up the some of the potential future benefit of a refinancing if interest
rates fall -- the investor's gain is your loss. Furthermore, the investment
has no marketability; if you need cash unexpectedly, you can't sell it.
This last problem can be avoided, however, by financing the points -- including
them in the loan amount. This is usually possible, as explained in Can
Points Be Financed?
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