When shopping for a mortgage loan, every lender will have different rates, fees and points for each loan program. When shopping for a mortgage loan, it is important to understand the three components of a Rate and Fee Quote: (1) Premium Rates (2) Lender Fees and (3) Discount Points.
A Premium Rate offer is any interest rate above the market rate (referred to as the “Par Rate”). While the Par Rate changes constantly during the day, most lenders will commit to a specific Par Rate early in the day. If the Par Rate is 6.00%, the lender will only earn revenue if they offer you a rate above Par (for example, 6.25%).
Lender fees are charged for services performed directly by the lender, which may include Processing Fees, Underwriting Fees, Origination Fees, etc. These fees are charged to offset the cost of processing, closing, and funding your mortgage loan.
Discount Points often represent the largest fees associated with your mortgage loan as one point equals 1% of your loan amount. If you are applying for a loan amount of $350,000 and pay 2 Discount Points, the Discount Point Fee would be $7,000. Borrowers may use Discount Points to obtain rates below the Par Rate. For example, if the Par Rate is 6.00%, a 5.75% rate would indicate that the Borrower will have to pay Discount Points.
Factors to Consider
Every lender provides multiple combinations of Rates, Fees, and Points across a variety of different programs. All of these choices can become overwhelming when trying to decide between different programs, rates, and fee packages. To limit the possibilities, it is often helpful to answer a few key questions:
How long do you expect to have this loan? Consider the probability of relocation, moving, or refinancing when determining your timeframe. Think in terms of 5 and 10 years.
Do you have the available cash to pay additional fees now to lower the interest charges later? Be sure that paying upfront fees is the best use of your money. For example, paying higher fees or points for a lower rate may not be a good use of cash while carrying high credit card balances.
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.
If you plan to have your loan for 5 years, paying 1 Discount Point on a $350,000 loan will cost you $3,500 upfront while saving you $88 a month. After 40 months of savings, you have recovered your upfront cost and will benefit from the lower rate. If you stay in the loan for 10 years, you will have created an additional $7,060 in interest savings over the life of your loan. Just like interest, points are 100% tax deductible in the year you pay them.
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.