Understanding Points and Buy-downs

 
    Points are prepaid interest. Each point is equal to 1 percent of the loan amount or $1,500 on a $150,000 loan, for example. Bankers, mortgage lenders, builders, home sellers, or anyone else can pay points so that they can offer lower interest rates and be more competitive.

For instance, a car dealer may advertise a lower than market interest rate on a new car model, which means, as you probably guessed, that the dealer has made an agreement with the bank and paid points to get a lower rate. A new homebuilder does the same thing to get a lower rate on mortgages they advertise on banners and flyers at their home site. As a home seller you can do the same by offering to pay points on a buyer's behalf so that they'll buy your home.

The bottom line is that points cost you money. Sometimes for good, other times not. If you understand points, you can work with them for your advantage and not get taken in.

     How Points and Buy-Downs Work

When you call a mortgage banker about a home loan, it's likely the lender will reel off a whole smorgasbord of interest rates. In addition to that day's interest rate (par), the lender will also give you the choice of several lower rates if you're willing to pay points. In this case, loan discount points are paid to the lender at closing to buy down the cur-rent interest rate, a rate that-along with the points-can change from day to day as the money markets fluctuate.

As mentioned, a point is one percent of the loan amount and is interest paid up front to increase the investor's yield or profit on the loan. For example, if you call a mortgage lender for the current rate, you might get 6.0 percent at par and 5.75 percent if you pay two points. On a $100,000 loan, this would add $2,000 to your closing costs to buy the interest down .25 of one percent for the life of the loan.

Points are normally charged by mortgage lenders to increase their up-front profit and offset the uncertainty of a loan that would normally go 15-30 years. However, since few mortgages go full term any-more because of sale or refinance, points can be an attractive incentive for investors to invest in mortgages.

As a rule-of-thumb, each point is approximately equal to 118 percent (.125) when buying down the interest on a 20 to 30 year mortgage. However, in a competitive market, if you shop around, it's possible to find discounts as high as .25 percent per point. Plus, how long you want to lock in the rate is also an important factor. A 30-day lock will have better terms than a 60-day one.

You usually have two choices when you begin the loan process: You can lock in the interest rate and points for thirty to sixty days. Or you can "float" and take whatever the market is the day you close. If you like to gamble and the rates are falling, this can be a good way to go. But, if you don't want to take the chance of getting caught by an upward spurt in interest rates, then locking the rate is the safest bet.

When a builder or seller offers to pay the bank a point or more to lower your interest rate, it's called a buy-down. Often builders increase the price of the home so that they can advertise an attractive interest rate. As a consumer, it's a good idea to ask the lender or salesperson how many points are built into the price of financing when the interest quote is lower than the current rate. There's no "free lunch" in mortgages. If you find an interest rate less than the current rate, someone is picking up the difference, and that's usually you.

Buy-down programs are varied and limited only by the lender's imagination. In addition to permanent buy-downs, there are three-two-one and two-one programs. With these temporary buy-downs, the interest rate is typically 3 percent less the first year, 2 percent less the second year, and 1% percent less the third year.

After the third year, the interest rate levels off for the remainder of the loan. And the two-one buy-down has only two years of reductions before it levels off.

Temporary buy-downs can be a two-edged sword. If the bank qualifies you on the first- or second-year rate, you'll be able to buy more home with the hope that your income will go up in the next few years to cover the increasing payments. A miscalculation of your future income or being overly optimistic can mean an uncomfortable payment increase each year for two or three years.

On the positive side, you can often qualify for more house using a buy-down. In a slow market sellers may be willing to pay a few points to help you buy their house if your qualifying ratios are tight.

       Is Paying Points Worth It?

It all depends on how long you're going to be in the house. Usually, if you plan on staying four or more years, then points can save you money. To determine how many months until you break even, sub-tract the payment if you buy down the rate from the payment if you don't buy it down and divide by 12.

For example, on a $100,000 loan at 6 percent for 30 years, the payment is $599.55. But, if you pay $2,000 and buy the rate down to 5.75 percent, the payment is $583.57, a difference of $15.98 a month. (Incidentally, if you had subtracted the $2,000 and gone with a $98,000 loan instead, the payment would be $587.56, about $3 more.) Dividing the $15.98 monthly savings into the $2,000 point cost shows that it wi11 be about 125 months before you break even and start saving $15.98 a month. This is hardly a barn-burner investment, but if you keep the home for the full 30 years, the savings will add up. However, most financial advisers don't recommend going beyond 36-48 months to recoup your point costs.

It's interesting to note that in the above example, if the interest rate were 9 percent, buying the rate down to 8.75 percent would result in a 112-month breakeven. The higher the interest rates goes, the more attractive points become in saving you mortgage interest.

The bottom line is that points are usually not a good investment as you can see from the numbers in the above example. However, if points are part of a seller or builder concession, it's better to take the buy-down than to subtract the concession from the sales price.