The process of buying your first home is a daunting one.
There is strange terminology (What’s an “escrow?” Why do I have to buy TWO policies of title insurance—and what am I insuring, anyway?), a mountain of paperwork to fill out and sign when you apply for your mortgage, and some numbers that can be quite overwhelming.
The confusion gets worse when your loan officer talks about rates. You already know that your interest rate affects your monthly payment; what you may not know, however, is that you have some control over the rate you will pay on your mortgage. Discount points play a part in both the up-front cost of your loan and the rate itself.
Before points make sense, the first thing you should know is how the lender calculates the rate you will pay. It is not a matter of deciding whether you are “worthy,” by the way. There are actual formulas to determine what rate you get before points are applied.
Risk-Based Pricing (Credit Score)
Most loans today are ultimately sold to Fannie Mae or Freddie Mac, the two mortgage giants who own or guarantee about 60% of all the loans in the country. They apply certain adjustments to the cost of individual loans based on a combination of the borrowers’ credit scores and the size of the loan as a percentage of the home’s value.
A buyer with a FICO score of 680 and a down payment of 20% will get a rate approximately .25% higher than a buyer with a score of 740 or higher. You should always discuss with your loan officer the effect of your credit score on the cost of your mortgage. You may find that paying off one credit card could save you thousands of dollars.
Interest rates are constantly on the move. They change because of the price investors are willing to pay for them on the open market. Rates commonly fluctuate up or down about 1/16% from one day to the next. Your rate is guaranteed when you instruct your loan officer to “lock” the rate.
The mysterious “points!” What are they? Should you pay them? A “point”—properly called a “discount point”—costs the borrower one percent of the loan amount. One point on a $400,000 loan is $4,000. It is a fee paid at the beginning of the loan. In most cases, it is your decision whether to pay for discount points.
When a loan officer looks at a daily rate sheet, he sees many rates, not just one, for each loan program. Some of the rates carry discount points (which cost you,) while others generate rebates from the lender (which gives you money back.) The lower the rate, the higher the points. The rate at which there are neither points nor rebate is called “par pricing.”
If you choose to pay points, you will get a lower interest rate for as long as you have the loan. It is sometime called a “permanent buy-down,” meaning that the effect of the up-front fee lasts for as long as you have the loan. As a rule, you will get a rate about .25% lower if you pay one point. To put that into perspective, if you are applying for a $400,000 loan, paying an additional $4,000 up front would reduce your rate from, say, 4% to 3.75%. Your monthly payment would be $57.00 lower.
Is it a good trade-off? If buying that home is a financial stretch, dropping your payment could help it fit your budget.
Negative Points (Rebates)
But what if available cash is more important to you than the monthly payment? Your loan officer will tell you that by selecting a higher interest rate, you will receive a rebate from the lender. You would receive this rebate at closing—and you would have to pay less cash to close escrow. Just as paying one point will drop your interest rate .25% below the par rate, raising your rate .25% above it would garner a lender rebate of around 1% of the loan amount—a $4,000 credit at closing in exchange for a slightly higher monthly payment.
If the “par pricing” is 4% today, the monthly payment for a $400,000 loan would be $1,910. Paying $4,000 to buy the rate down to 3.75% would drop the payment by $57.00, to $1,852. Selecting a 4.25% rate (above par) would give you a rebate of about $4,000, but at a cost of $58 per month over the par rate. If you are struggling to scrape up enough cash to buy, that $4,000 rebate could be a life saver.
Ready to Get Started?
Get our roadmap to home ownership, Getting Approved: What Every First Time Homebuyer Should Know in 2016. This informative e-book will give you a complete roadmap to the steps you need to take as you start your journey to home ownership.