Should You Pay Points for a Low Interest Rate?

With the recent rise in interest rates, does it make sense to pay a percentage point (1% of the loan amount) to get a lower interest rate?

That’s a good question, and I’ll tell you how I determine the answer, based on your individual situation. But first, for those who are not familiar, I’ll explain how you can a lower interest rate by paying a point.

What Does Paying a Point Mean?

Let’s say today’s interest rate for a 30-year fixed rate is 4.25%, but you would really love 4.0%. You can opt to buy down your rate by paying one percent of your loan amount as an upfront closing cost. For example:

\$200,000 loan, 0 points, 4.25% = \$983/mo. principal and interest

\$200,000 loan, 1 point (\$2,000), 4.0% = \$954/mo. principal and interest

By paying \$2,000 upfront, you save \$29/mo. on your payment.

How to Determine If Paying a Point is a Good Choice

Calculate the monthly payment (principal and interest only) for your loan amount using the two interest rates that are available. Then subtract the smaller payment from the larger payment to get the savings. This is X.

Now divide X into the upfront cost. That will give you the number of months it will take to break even.

If you plan to keep your loan longer than that, you’ll come out ahead by paying the point. But wait! If it takes too long to break even on your money, it doesn’t make sense–even if you do plan to stay in your house for that long. You don’t want to wait five years to just break even, because there are better things you could do with that money.

Let’s look at our example above:

\$2,000 upfront cost divided by \$29 savings = 68.9 months or 5.7 years

Waiting almost six years just to break even on my \$2,000 is something you want to say “no thank you” to doing. If you don’t need to keep that money in savings for emergencies, you could do better by putting it toward your principal balance when you make my first payment.

How One Home Buyer Saved \$2,234!

Last month, a U.S. Veteran who was buying a home using the zero down VA loan signed up for my coaching service. He emailed me the Cost Estimate Worksheet for the lender he was planning to use. He chose this lender because it had received so many positive reviews online. The loan officer was very nice and accommodating, so he felt confident, but decided to have me check his paperwork as a safety measure.

When I looked at his estimate, I was not pleased! He was getting an interest rate that should have been zero points, but he was paying 1% or \$2,234. That is in addition to the lender’s fees of underwriting \$495 and processing \$395. After our telephone consultation, he knew what he had to do.

The next day, he had a loan with the same low rate, no points! Needless to say, he is happy he used my coaching/consultation service to save himself \$2,234 in upfront cash. Now he can use that money for his own good!

Look at Interest Rate Options Before You Lock Your Rate

Before you lock in your interest rate, insist on being given at least two choices. If you could pay a point and lower your rate enough that you would come out ahead after only 1.7 years (as happened for another one of my coaching clients), then it is worth the cost–assuming you have the available cash without financial hardship, of course.

Sometimes, you need to pay only a fraction of a point (less than 1%) to get a lower rate. It varies from day to day. There is no set formula.

A good loan officer will offer you options. But if he or she fails to do so, ask for options. This is your home, your mortgage, and YOU should be the one who chooses your interest rate. Just make sure you do the math so that you choose your best option.

And remember, you cannot lock in your rate until you have submitted a fully signed purchase contract to the loan officer. Interest rates are tied to a specific property address. So wait until then to do your interest rate/point comparison.

I was listening to my radio when on came yet another ad by a local mortgage company. Maybe you’ve heard a similar ad and wondered if it was a great company to get a loan from. Or maybe you’re a real estate agent and wondered if this company could get your buyers good financing.

In this ad, the owner of the mortgage company was telling listeners about his fantastic, historically low interest rates and APRs (Annual Percentage Rates). Fine, no problem. But then he capped off the ad by saying, “With us, you never pay an upfront fee!” Like it some kind of unique, special deal: no up front fee.

THE TRUTH: Federal banking law forbids any mortgage lender–including banks, direct lenders, credit unions, or brokers–from collecting any money up front, unless you want them to pull your credit report; and in that case, they can ask for payment for the credit report only (which is normally less than \$30).

It is illegal to ask you to pay a few hundred dollars, for any amount whatsoever, for an application fee, processing fee, acceptance fee, or any other type of fee. Other than paying for the credit report, a lender must not ask for any money without first providing you with a Good Faith Estimate.

If you already know your credit score or know that you have excellent credit with at least three accounts on record, then there is no need to have your credit report pulled before you are ready to commit to that lender. If you are shopping for a good loan, do not disclose your social security number or let the loan officer pull your credit.

Ask the loan officer for a Cost Estimate or a Fees Worksheet. It doesn’t matter what they call it, the up front estimate does not require a credit report pull. Before 2010, it was the Good Faith Estimate that was given up front; now it is the Cost Estimate. It’s the same thing, different title at the top of the page. Due to (insipid) federal regulations, lenders were forced to change the title of the upfront estimate. You have the right to receive this without cost, obligation, or credit pull.

The radio ad I heard, the one bragging about “we have no upfront fee” was on Christian radio. So listener beware: just because an ad is on your favorite station, it doesn’t make it 100 percent honest. No upfront fee is the law. Touting it as unique to your company is a marketing ploy. So if you don’t like shady ploys, ignore those ads.

Lowest Interest Rate Mortgage

The lowest interest rate mortgage programs make good sense for some people. But not for all. I’ll explain.

The longer an investor guarantees your interest rate, the higher the risk is to the investor. Therefore, the 30-year fixed rate program has a higher rate than the 15-year fixed rate. And the 15-year fixed rate is higher than the 10-year fixed rate.

The adjustable rate programs that guarantee your rate for less than 10 years offer the lowest interest rates. Today, I received in the mail a very attractive rate offer of 2.55%/2.88% APR. Let’s take a closer look.

You get 2.55% guaranteed for the first five years. After that, the rate will adjust based on Prime Rate + 0%. This means you pay about 1% less than the 30-year fixed rate, which is currently at 3.5%.

If your rate now is 4.5%, then refinancing to 3.5% probably is not going to make sense, after you account for the closing costs. But if you lower your rate by 2%, then it might. Here is a scenario for which it could make good sense:

* Your loan balance is fairly low.

* You continue paying your current payment with the extra going toward principal balance. Ideally, you would be a person who is already paying more and you would continue doing that. This way, your balance would drop significantly each month; especially with only 2.55% going toward interest.

* Your goal is to own your home free-and-clear as soon as possible.

After five years, you would have a very low or no balance. If a small balance was remaining, say \$50,000 or less, then even if the interest rate was higher, it would not be problematic. With an adjustable rate, your new payment will be calculated based on the Prime rate and your current lower balance. So even if the rate goes up at the five-year mark, your payment probably would not exceed what you’re paying now anyway.

Don’t Take This Loan If…

* You are not 100 percent confident you can continue paying the higher payment — and will continue to do so. If you’re the type who might give into temptation to make the minimum payment due, this is not for you.

* Your balance is high, such that after five years, you will still have a significant balance owing.

* If you are the type of person who will lie awake at night fretting over what rates might do in the future.

Fine Print on This 5/1 ARM Offer

With the offer I’m looking at, closing costs are only \$495. No prepayment penalty. Relock your rate any time you like.

If you’d like to consider this loan for yourself, please feel free to shoot me an email via my “Ask Carolyn a Question” page. You’re also welcome to post a comment or question.