Are customers who stay in their homes for more than five years losing money?

Consumers overwhelmingly select no-point mortgages despite the higher overall cost. In many cases, borrowers are adding thousands of dollars to their annual mortgage bill by foregoing points and, as a result, increasing the long-term interest rate of their home mortgage.

Ironically, even though many homebuyers are attracted to no-point loans by the prospect of saving money, the vast majority are making poor economic decisions. Points, pre-paid interest collected upfront by lenders, are usually paid at closing. In exchange for points up front, lenders offer a lower interest rate on the loan.

Fixed-Rate Loans

One point equals one percent of the total loan amount, so on a mortgage of $100,000, one point translates to $1,000. On a 30-year fixed loan, the most common mortgage product, each point ordinarily results in a rate reduction of 0.25 percent. So, for example, a loan of five percent at no points will usually be lowered to 4.75 percent with one point paid or 4.5 percent with two points paid.

Loans with this kind of traditional "buy-down" break even after about five years. In other words, consumers who plan to stay in their property longer than five years will almost always benefit by paying points. In addition, the lower interest rate causes the loan to amortize more quickly; thus, the proportion of each month’s payment allocated to principal reduction is increased, resulting in even greater savings.

And on top of that, points can typically be deducted in the year they are paid on a purchase transaction, reducing the break-even point even more. When all these savings are factored in, it rarely takes more than three years to start benefiting from the lower payments derived by paying points.

Other Considerations

Despite these mathematical realities, no-points mortgages have stayed popular since they were introduced almost 20 years ago, and most borrowers perceive no-point mortgages as less expensive. Borrowers are often lured by the appeal of avoiding upfront charges and, in many cases, complicated advertising can obscure the actual cost of the no-point mortgage. The APR (annual percentage rate), legally required in advertisements to help borrowers compare loans, can fail to clarify the break-even point or the role rates play in the overall cost of the loan.

Borrowers should also consider the likelihood of refinancing in the next five years. In that case, they may be unable to recoup the points in time, but today, with so many people locking in loans at the lowest rates ever, the opportunities for refinancing will probably remain low, and the benefits of paying points can result in a financial windfall.

Conclusion

While no-point mortgages can help people with cash-flow hurdles, customers should ask themselves how long they plan to live in their new home. If the purchase encompasses a long-term commitment, they would likely save a substantial amount of money by paying points.