Mortgage loan costs are important to understand when financing the purchase of real estate. Mortgage lenders commonly charge borrowers a variety of different fees, collectively known as closing costs, to obtain a mortgage loan. Some of these are standard, fixed fees charged by a lender on all mortgage loans. One fee that has some variability in how it is applied is the discount point.
Discount points, also known as an origination fees or points, are initial interest charges prepaid by a borrower to lower the interest rate on a mortgage. One point will cost the borrower one percent (1%) of the loan amount and typically lowers the interest rate by one-eighth percent (0.125%). For example, if the mortgage interest rate is 5.50% without any points paid, and the borrower pays two points, the lender will decrease the interest rate to 5.25%.
Should a borrower pay points to lower the interest rate on a mortgage loan? Paying zero points minimizes the initial cost to obtain the loan but results in a higher repayment cost going forward. Paying some points will increase the initial cost to obtain the loan but reduces the repayment cost going forward. The decision of whether a borrower should pay one or more discount points can be evaluated by conducting a break-even analysis.
Some professionals will try to present the break-even analysis in the following manner. A borrower wants to obtain a $200,000 mortgage loan. The interest rate without paying any points is 5.125%. Paying one point will add $2,000 to the borrower's closing costs and will lower the interest rate to 5.0%. Due to the lower interest rate, the scheduled monthly payment will be reduced by $15.33 per month. At a savings rate of $15.33 per month, the borrower will save a total of $2,000 in monthly payments over a period of 131 months, or almost 12 years. If the borrower plans to keep the mortgage 131 months or longer, then paying the one point would save the borrower money. If the borrower plans to keep the mortgage less than 131 months, then paying the one point would not save the borrower money. This break-even comparison seems easy enough, right? The problem is this evaluation is oversimplified. This method of comparison is inadequate and presented here only to demonstrate what not to do.
To accurately determine whether a point should be paid, the break-even analysis should consider the difference in monthly interest costs, not the difference in monthly payment costs. Revisiting the previous scenario, by lowering the interest rate from 5.125% to 5.0%, the interest portion of the monthly payment will be reduced by $20.83 in month one. The interest portion of the monthly payments decreases slightly each month, so loan amortization tables must be referenced to compare the difference in interest paid each month. Comparing the cumulative monthly interest that would be paid with each loan shows the borrower will save a total of $2,000 in monthly interest payments over a period of 98 months, or about 8 years. If the borrower plans to keep the mortgage 98 months or longer, then paying the one point would save the borrower money. If the borrower plans to keep the mortgage less than 98 months, then paying the one point would not save the borrower money. As you can see, this break-even point is much sooner than the 131 months that was calculated previously.
Why should we compare the difference in monthly interest payments rather than total monthly payments? The total monthly payment is comprised of two parts: principal and interest. The borrower benefits by reducing the portion of the payment that goes towards interest because that means more of the monthly payment goes towards principal. The more principal the borrowers pays, the more the outstanding loan balance is reduced. When the borrower sells the real estate, having a lower outstanding loan balance to pay off results in the borrower keeping more of the sales proceeds. We compare the difference in monthly interest payments because the borrower should not be concerned with only the monthly payment savings but also the total gain realized when the real estate is sold. A lower interest rate on the mortgage loan provides a lower monthly payment and a faster accumulation of equity in the real estate. Borrowers should consider both of these important factors when evaluating whether to pay points on a mortgage loan.
Resources: Glossary of Mortgage Terms
