June 22, 1998,
Revised January 10, 2003, Revised Nov. 11, 2004
"A friend from
the UK told me that over there mortgage borrowers don�t pay points, just
an interest rate. Why do we have to pay points here?"
What Are Points?
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, 3 points means a payment of $3,000.
Points are part of the cost of credit to the borrower, and part of the
investment return to the lender.
Must a Borrower Pay Points?
Your friend is quite right in
saying that points are unknown in the UK. In fact, to my knowledge, they
are used nowhere except in the US. The international housing finance
seminar that the Wharton School holds every May has hosted bankers and
officials from at least 60 countries over the last 10 years, and none of
them have been familiar with points.
But you are wrong in thinking
that a borrower in the US must pay points. While the quotations you
see in the press usually include points, the fact is that virtually all
lenders are willing to make no-point loans if you ask for them. But of
course the rate will be higher. The rate/point quotes you see in the media
are what the lenders view as their "base" terms. But they have
other rate/point combinations "in the drawer" to be trotted out
when needed.
For example, a
lender quoting 7.25% and 2 points might in fact be offering all of the
following combinations:
|
6.75%
and 4.50 Points
|
|
7.00%
and 3.25 Points
|
|
7.25%
and 2.00 Points (Quoted)
|
|
7.50%
and 1.00 Point
|
|
7.75%
and 0.00 Points
|
Lenders also offer negative points, or rebates, at even higher
rates. These are discussed in Can
Mortgage Points Be Negative?
Having the option to select
from this type of menu in itself is a positive feature of the US system.
The down side is that points add one more complexity to a process that is
already complicated enough. The reason lenders usually keep all the
combinations but one or two in the drawer is that they fear overwhelming
the borrower � and perhaps losing the loan to another lender who makes
it simpler.
Selecting
the Best Rate/Point Combination
Some borrowers have little or
no leeway because they are "cash-short" or
"income-short". If they are cash-short, they are obliged to avoid
points so that they will have enough cash to complete the deal. If they are
income-short, they must accept the lowest rate available so that the
mortgage payment won't be viewed as excessive relative to their income.
If you are not constrained in
either of these ways, you should be guided by two factors. The first is
your time horizon. If you expect to
have the mortgage a long time, paying
points to reduce the rate makes economic sense because you are going to
enjoy the lower rate for a long time. If your time horizon is short, avoid
points and pay the higher rate because you won�t be paying it for long.
How long is
"long"? This is shown for you in calculator 11a, The
Break-Even Period For Paying Points on Fixed-Rate Mortgages,
and a companion calculator 11b applicable to adjustable-rate mortgages.
Note that you may have a
short horizon because you expect to move soon, or because you expect that
interest rates will soon drop and you will be
refinancing. I don't advise basing your estimated time horizon on
interest rate expectations because you can't forecast interest rates.
The
second factor is your opportunity cost. What could you do with the money
if you didn�t use it to pay points? Even if you expect to be in your
house a long time, there could be other uses for your money that take
precedence over the long-run savings from a lower interest rate.
A useful way to pull these
factors together is to look at the payment of points as an investment that
yields a return that rises the longer you stay in your house. This return
can be compared to the return on other investments available to you.
The return from paying points is shown for you in the calculator11c Rate
of Return From Investing in Points on Fixed-Rate Mortgages, and a companion
calculator 11d applicable to adjustable-rate mortgages.
Copyright Jack Guttentag
2004
