Points is Points
The best chance to waste money while getting a mortgage is to misunderstand the relationship between discount points, origination fee, and the interest rate on the loan.
Borrowers carry the intuition that the lowest interest rate is always the best deal, and expect to pay some sort of loan fee and “point” along the way somewhere. This intuition is half right: the lowest rate is a good idea, but it’s not worth paying
for.
Mortgage jargon contributes to the confusion: “origination,” “discount,” and “point” require definition.
When a loan is created at an interest rate below the bond market’s desired yield, the market value of the loan is less than its face value. Just like a bond, the loan is said to trade at a “discount.”
If the market wants 8.00%, and you are determined to pay no more than 7.875%, you must make up the difference between the face value of the loan (100 cents on the dollar), and its market value. In the inexorable time value mathematics of the bond market, the 7.875% loan would be worth 99.50 cents on the dollar, and you would have to pay .50% in “point” to get your rate.
Before exploring the wisdom of paying such a fee for a lower rate, we still need to define this “origination fee” business.
In the dark ages of mortgage lending, back before 1983, origination fees were the primary compensation for mortgage people. Today, an origination fee is exactly the same thing as a discount point. (In the modern era, we get paid for creating and selling the right to service a loan: long story, separate column).
Loan origination fees are still quoted separately from discount points out of historical habit, and perhaps the hope that borrowers will lose track of the real price. Worse, origination fees are often treated as automatic and inescapable (in
the rate quotes near this column, note that origination fees are omitted altogether, thereby making the rates look lower than they really are).
This antique pricing system leads to the absurd mortgage patois of “pluses.” Such and such a rate costs “a half plus one,” while a lower rate might cost “two plus one,” the first number referring to discount points, and the second to origination.
Ask your banker to quote total points. Any fee charged as a percent of the loan amount is a point, and present in the deal to buy down the interest rate.
Having defined terms, is paying points a good deal?
Nope.
Never? Never is a long time. If you promise not to move, or refinance within six years, paying points will turn out okay.
“Breakeven” or “recapture” math goes like this. On a $100,000 loan, each oneeighth (.125%) in rate usually costs .50% in point ($500). Each eighth in rate amortizes to about $8.70 per month. If you divide the monthly benefit ($8.70) into the cost ($500), you get the number of months it takes to recapture the fee you paid. In this example, 57 months; but really closer to six years because you paid the fee in 1996 dollars, and 57 months hence, $8.70 won’t be worth $8.70. If you sell or refinance in less than six years, you leave money on the table.
This inevitable point versus rate relationship is one of Wall Street’s great selffulfilling prophecies. In the 60 years since the FHA created the first 30-year loans, the average loan life has always been about six years. If the average loan lasts six years, the Street wants fee compensation for six years of deficient interest.
Always try for the lowest fee package at a given rate, clear down to “zero plus zero,” if you can find it. See, in the mortgage business, the highest virtue is pointlessness.