Should you pay points? What are points? Is that money going directly into the Loan Officer’s pocket? Well, that depends. This article will look at these questions as well as a few others to see which strategy makes the most sense in the long run. We’ll also look at the math to calculate when points make sense and when they don’t.
Let’s start with the definition. A point is 1% of the loan balance. So if you’re getting a $500K loan, one point is $5000. The ‘standard closing cost structure’ will include one point. In fact, the first point is referred to as ‘origination’. The origination is the fee to ‘originate’ the loan. So that first 1% goes directly to the Broker. And depending on your Loan Officer’s volume, he or she will get some percentage of that money.
The remaining portion pays for the lights, the office space, the furniture, photocopier and so on. Part of that money goes to the Loan Officer and the rest pays for the office. That explains the origination. Anything beyond that is referred to as ‘points’ and points are actually prepaid interest; money that goes directly to the Lender. And in exchange for that prepaid interest, the Lender offers a lower interest rate, lowering your payment. We can calculate the breakeven for the decision. You either pay more up front and get a lower payment or you pay less up front and get a higher payment.
Before we look at the math, we have to address a couple of issues. For starters, the points and origination are tax deductible so they don’t cost you as much as it may appear at first blush. If you’re getting a $500K loan (1 point is $5000) and depending on your tax rate, that point may only cost you $3000 or $3500 on an after-tax basis. You’re either paying that money to the government or you’re using it to buy down your interest rate. When calculating the breakeven, always use the after-tax cost.
Secondly, one point buys different amounts depending on what loan you’re getting. If you’re getting a 30-year fixed mortgage, one point will reduce your interest rate by about 0.25%. With loans that are fixed for 5 or 7 years, one point will reduce your rate by about 0.375%. These are not exact figures. They vary by lender and by program. If you’re getting a 2-year fixed loan, one point would reduce your rate by a full 0.50%. The shorter the fixed period, the more one point will buy.
What’s the breakeven for buying the interest rate down? Well, for a 30-year fixed mortgage, the breakeven is usually between 3 and 4 years. In other words, if you sold the property or refinanced the mortgage within 3 or 4 years, you would’ve paid more money buying the rate down. The lower interest rate results in a lower monthly payment but it would take between 36 and 48 months to get the initial investment back. If you kept the house for longer than 3 or 4 years without refinancing, you would’ve recaptured the entire initial investment and be saving money each month for as long as you keep the mortgage.
For a 5/1 ARM or a 7/1 ARM, the breakeven is about 18 months to 2 years. That’s a much shorter period of time because one point buys more in these loan programs. For a 2-year fixed, the breakeven is usually just 14 or 15 months. So if you kept the mortgage for the first two years, you would’ve already saved money by buying the rate down at the beginning. Mathematically speaking, most people are better off buying the rate down.
The problem is that ‘points’ don’t sound very good. It sounds like you’re getting ripped off. Brokers know this so they generally don’t tell you the reality because they’re worried it’ll make their quote appear less competitive. But the reality is that they can help you save a bunch of money if you don’t refinance every year or two. And with lower interest rates behind us, the refinance boom is definitely over and people who refinance now should plan to keep their mortgages for as long as possible. Remember, it doesn’t matter what anybody tells you, refinancing costs money and you should try to do so as little as possible.
The industry has gone beyond avoiding ‘points’. They’re actually avoiding the origination as well. Again, the origination is the first 1% and most people mistakenly refer to it as a point, even though it’s technically different. Anyway, the industry’s been marketing ‘zero point’ loans for a few years already and most people jump at it, thinking they’re saving money. Well, the same math is true for the first 1% as for the second or even the third. If you’re not paying the 1% origination as a closing cost, rest assured, it’s hidden in a higher interest rate. Nobody’s doing loans for free out there and most banks have a minimum 1% origination anyway so you’re paying for it one way or another.
The reason this works is because Lenders pay Loan Officers rebates for loans with rates higher than the current market rate. Assume certain circumstances regarding credit, income and assets yields a market rate of 6.5% and the Loan Officer sells the loan with a rate of 7%, the Lender will pay the Loan Officer a rebate on that loan. If the closing costs do not include the origination, the Loan Officer just needs to raise the interest rate high enough to get a rebate of at least a 1%. And if they want to make more than 1%, they only need to raise the rate a bit more.
This goes even a step further when Loan Officers market ‘no cost loans’. Again, refinancing costs money and the fees associated with a purchase or refinance get paid one way or another so if they’re not itemized in the closing costs, they’re hidden in a higher interest rate. In today’s lending environment, you can mark up a loan so high that you get 2 or even 3% rebate after the loan closes. Don’t get fooled by ‘no cost loans’. It’s just a marketing gimmick.
There are four main categories of closing costs. First, you get the origination and any points you pay to buy the rate down. The second is the lender fees including underwriting and processing. Third, you get all the third-party fees like the credit report, appraisal, flood certification, notary and tax service. The forth category includes the escrow and title fees such as recording, settlement, courier and title insurance. For purchase transactions, there’s one more category for transfer taxes. In California, transfer taxes range from $1.10 per $1000 to almost $15 per $1000 in some municipalities.
For origination and points, you can calculate it yourself. The origination will be 1% of the loan balance. If you have a first and second mortgage, it will be 1% of the combined mortgages. If you’ve decided to buy the rate down with extra points, just add an additional 1% for each point you’ve decided to buy. If you’ve got two loans, the points probably only apply to the first mortgage. You could buy the rate down on the second mortgage as well but it’s less common.
The second category is lenders fees. These fees vary widely. Some lenders have underwriting fees as low as $350. Others are as high as $1300 or even higher. Also, if you have a second mortgage, there may be a second underwriting fee and I’ve seen those as high as $600. Another fee you’ll see is processing. That’s another lender fee and I’ve seen those range from about $250 to $1000.
Here’s my opinion on lender fees. If they’re charging a lot for underwriting, they’re probably using that revenue to help subsidize competitive rates. It’s just a different strategy. It’s not like some lenders are making huge profits while others are making nothing. The lending community has become extremely competitive and individual companies will try to get their revenue from different places. At the end of the day, these fees will be fully disclosed through the APR and that’s always the best way to determine the competitiveness of your quote.
As for processing, anything over $500 is a rip-off. All Loan Officers have processors. They’re real people who process real loans and chase all the conditions required by the Lender. It’s a tedious job and these people have to get paid somehow. I’ve got no problem with a processing fee as high as $500. Personally, I charge $395 for processing. But a processing fee of $1000 is a complete rip-off and I would push back hard on anyone trying to charge me that much.
Third party fees are next. In California, you can expect to pay from $350 to $500 for your appraisal depending on what format the lender requires. You can expect $15 or $25 for your credit report, $25 to $75 for tax service, $10 to $20 for your flood certification and $60 to $200 for your notary. Why such a big variance for notary? Because you can have a mobile notary come to your home for the signing. That’s a lot more convenient but it’ll cost you, usually $150 for a single mortgage and $200 for a first and second combo. I should know. I had a signing service before I started originating loans. If you sign at the Title Company, the notary fee is usually $60.
The forth category includes your escrow and title charges. Escrow fees will range from $250 and $900, depending on the size of the transaction. Expect between $100 and $160 for recording and $35 to $100 for courier services, depending on how many times the documents have to be couriered around. Title insurance is frequently the second largest fee on the closing statement, next to the origination. Title insurance can run you anywhere from $500 all the way to $3000 or more, depending on the value of the property.
All of these fees constitute what’s called ‘non-recurring’ closing costs. That means they’re all one-time fees. There’s another category of fees called prepaid items or ‘recurring’ closing costs. These are bills you would’ve had to pay at some point anyway. But because of the transaction, some of those bills are collected ahead of time. These generally include prepaid interest, property taxes, hazard insurance and, in some cases, HOA dues.
A major distinction with prepaid items is whether or not you have an impound account. An impound account allows your property taxes and hazard insurance to be collected at the same time as your mortgage payment. The obvious advantage is that you don’t have any surprise bills during the year and your monthly housing payment includes everything. But the downside is that you have to put some money aside in a reserve account at the time the transaction closes. That means you have to bring more money in at closing, giving the illusion of higher closing costs. In fact, it’s your own money and you’ll eventually get it back but it’s worth discussing with your Loan Officer before you get to the signing.
Overall, if you decide not to have an impound account, you can bank on closing costs and prepaid items between 2% and 2.5%. If you decide to include an impound account, you can expect between 2.5% and 3% in total closing costs and prepaid items. These are generalizations to be sure but they give you a fairly good idea of what to expect.