The Role Of Mortgage Points In A Low-Rate Market
Mortgage points are an upfront payment to the lender, expressed as a percent of the loan amount. For example, one point on a $320,000 loan is $3,200.
Points are part of the price of a mortgage, along with the interest rate, and can be positive or negative. Positive points are payments made by the borrower in exchange for a lower interest rate. Negative points, called “premiums”, are payments made by the lender as an offset to costs in exchange for a higher interest rate.
In an abnormally low-interest rate market, the focus of borrowers is, or should be on paying points for a lower interest rate. The reason is that the payment of points is akin to an investment in the sense that it involves an outflow at the beginning and a set of inflows in the future. A rate of return on the payment of points can be calculated that is comparable to the return on investment products such as corporate bonds and bank CDs.
When the returns on these other investments are unusually low, as they are now, paying points becomes an attractive investment for consumers financing a house purchase or refinancing an existing mortgage. If the funds used to purchase points are yielding 1%, for example, paying points is a better option than when the funds are yielding 6%.
In addition, the rate of return on an Investment in points depends heavily on the life of the mortgage on which it is based. The longer the life, the higher the return. The low-rate mortgages now being written have a long expected life because future refinancing prospects are negligible.
Here is an example of price quotes on a high-quality 30-year loan of $320,000 taken from my web site on October 22, 2020. A rate of 2.75% carried a small premium of 0.27% or $861. A rate of 2.25% required points of 2.27% or $7,261. The upfront cost of reducing the rate from 2.75% to 2.25% was thus $8,122. The rate of return on that investment depends on the life of the loan, as shown below.
The moral is very clear. Borrowers who might move within the next 5-6 years should avoid paying points. A horizon beyond 6 years is a great investment.
The figures in the table above were calculated using my Mortgage Points Calculator 11C.