Friday, January 25, 2008

Points and Their Uses

Even though I am not a mortgage broker, I do counsel people a lot with respect to the actual cost of renting or owning an apartment. One question I get asked a lot is "What are points?"

In mortgage terms, a point (literally a percentage point) is essentially prepaid interest - you pay a percentage point of the mortgaged amount at closing, and in return, you get a reduced interest rate for the life of the mortgage.

Here's an example:

You are taking a mortgage of $100,000 to complete the purchase of a new apartment (cheap apartment, but these do exist!). You qualify for a 30 year fixed mortgage (360 monthly payments) at a rate of 6% with no points. Your monthly principal and interest payments will be $600 for the life of the loan.

Then, your loan officer asks you if you want to pay a quarter point to lower your interest rate. You can pay 1/4 of 1% of $100,000 ($250) at closing, and in return your interest rate gets lowered to 5.75% for the life of the loan.

Using a mortgage calculator like the one found here, we can see that at 5.75%, your mortgage payments will go down to $584, a difference of $16 from the 6% rate.

If you divide 250 (the interest that you prepaid) by 16 (the amount you save per month), you will get 15.65 (rounded up to 16), the number of months it will take for you to break even on paying the point. Every month afterward, you are saving $16 by having paid that extra $250 at closing.

If you stayed in that same property for the entire 30 year life of the loan, and did not prepay it, you will have saved $5,504 by paying $250 at closing.

You could also purchase a half-point for $500. This would bring your interest rate down to 5.5% and your mortgage payment to $568 per month. This prepayment would also pay for itself in 16 months, and you would save $11,608 over the life of the loan.

The question is: How long do you plan to own the property (for residence or investment)? Most people who go ahead and buy properties are going to stay there for at least 16 months, although unforeseen life changes can alter that.

Keep in mind also that you can get the same interest savings by paying approximately $9 extra principle with your mortgage payments every month, a total of $609 per month. But, if you are short on extra cash at the time of closing, that may be the way you choose to go, particularly if your expect your income to rise over the years.

In the end, each individual buyer has to make his own decision. If you are looking for every to keep your monthly obligations low, it might make sense to pay a quarter or half point to get your interest rate lower. But, if you don't have that extra money to put to closing costs, and you think your income will rise over time, you might as well pay no points and then commit to pre-paying your principle to achieve the same interest savings. Or, you can pay the point, then commit the entire extra $25 /month to prepay your mortgage, resulting in further interest savings. None is a bad idea.

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