Mortgage Points: A Powerful Option That Is Often Neglected

03/25/2015 07:27 pm ET | Updated May 25, 2015

What Are Points?

Mortgage points are an upfront payment to the lender, expressed as a percent of the loan amount. For example, one point on a $210,000 loan is $2100. Points are part of the price of a mortgage, along with the interest rate.

As I write this article using one of the twin monitors connected to my computer, the other monitor shows an array of interest rate/point combinations on a 30-year fixed-rate mortgage of $210,000 as of March 12. There are 17 combinations, ranging from $14,809 at 2.875 percent to negative $12,436 at 5.125 percent. Negative points are called rebates, which can be used by borrowers to pay third party costs (such as title insurance) and to fund escrow accounts.

Potential Value of the Option

Points are a unique feature of the US system; to my knowledge they are found nowhere else in the world. They offer borrowers a way to tailor the terms of the mortgage to their individual needs. Here are examples which will be compared to a benchmark borrower who selects a rate of 3.50 percent that is closest to zero points.

Borrowers who don't expect to have their mortgage very long can minimize their total mortgage costs over its life by paying a high interest rate in exchange for a rebate. The rebate reduces their upfront costs and they won't pay the high interest rate for very long. If the borrower's time horizon is only 3 years, taking the 5.125 percent rate with a $12,894 rebate will cost $6800 less over 3 years than the benchmark combination of 3.5 percent and $1,294 in points.

Borrowers with a long time horizon can minimize their costs by doing the opposite. It is cost effective for them to pay points that reduce the interest rate, because they will have the low rate for a long time. If the borrower's time horizon is 25 years, for example, taking the 2.875 percent rate with $14,989 in points will cost $6600 less than the benchmark combination of 3.5 percent and $1,294 in points.

Borrowers who are cash-short can opt for a high rate/rebate combination to reduce their cash drain. The borrower who elects to take the 5.125 percent rate rather than the benchmark rate of 3.50 percent will reduce the upfront cash required to close by $14,200.

Borrowers who need to make their monthly payment more affordable can opt for a low-rate/large point combination to reduce their payment. The borrower who elects to take the 2.875 percent rate rather than the benchmark rate of 3.50 percent will reduce the monthly payment from $943 to $871,

There are potential conflicts in these objectives. The borrower with a short time horizon and a payment affordability problem has to decide which gets priority, and the same is true of the borrower with a long time horizon who is cash short. The advice I give on my web site is to select the interest rate/points combination that minimizes total cost over their time horizon, subject to the payment being affordable and the cash requirement being manageable.

Poor Decisions Are Common

Borrowers frequently don't choose the combination that is best for them for the same reasons they often don't select the best type of mortgage: their own ignorance, poor advice and inadequate disclosures. Some borrowers don't understand that there is a choice to be made, and their loan provider (loan officer or mortgage broker, henceforth LP) may have no interest in taking the time to explore an issue that can be avoided.

One way to avoid it is to simply steer the borrower toward the rate that is closest to zero points -- what I have called the benchmark rate. While steering borrowers toward a mortgage that carries a larger commission for the LP is now illegal, it is not illegal to steer a borrower toward the mortgage that involves the least time and effort for the LP.

Borrowers saddled with LPs who would prefer not to be bothered should take control of the decision process themselves. If they have access to the relevant data, borrowers do not need a PhD to find their own best path.

Data Requirements

What borrowers need is a schedule covering the particular type of mortgage they have selected, such as a 30-year fixed-rate or a 5/1 adjustable rate. The schedule should show, for every available rate/point combination, the initial monthly payment and the total cost of the mortgage over the period that is the borrower's best guess of how long they will have the mortgage. Total cost should include upfront fees, monthly payments and lost interest and should be net of tax savings and balance reduction.

As far as I know, my web site is the only place where a borrower can find this feature. You can use it for free at Which Type of Mortgage Will Minimize Your Costs.

For more information on mortgages in general, or to compare mortgage offerings from multiple lenders in a fair, unbiased environment please visit my website The Mortgage Professor