Which is Worse, Higher Interest Rates or More Points?
Saving a lot of money on a mortgage isn't all that complicated. Get a lower interest rate and save. Get a higher interest rate and pay more. So, shopping around for the best interest rate can be very beneficial to your bottom line.
Have you ever wondered where a point enters into the equation? Though it can be very confusing, don't overlook the number of points you pay on your mortgage. Even a lower interest rate mortgage can go from being a great deal to a bad one because of points. Let's see if we can un-muddy the waters where points are involved and give you an edge when you are shopping for a mortgage.
First of all, what is a point? A point is 1%, period. If you were receiving a $200,000 mortgage on your home that called for a 1-point payment at closing, you would be paying 1% of $200,000 or $2,000.
More commonly, a mortgage writer will charge you 2 or 2 1/2-points. With a 2 1/2-point charge, a $200,000 mortgage will cost you, 2 1/2% of $200,000 or $5,000.
You may wonder what happens at your closing. Does that $5,000 come right out of your pocket and go directly into the lender's pocket? Not exactly: in the case of a refinance, the $5,000 is taken out of the cash back you would receive at closing, but when purchasing a property, the $5,000 is added on to your mortgage principle amount. In other words, that $200,000 mortgage at 2 1/2-points becomes a $205,000 mortgage.
Now, let's suppose you were offered this $200,000 mortgage with 2 1/2-points charged at a 6% interest rate and the loan was for 30 years. At the same time, another lender offered you a $200,000 mortgage at 7% for 30 years but this mortgage was a 0-points mortgage. Which is the better deal for you?
With the 0-point mortgage, $200,000 at 7% over 30 years, your monthly payment would be $1,330.60. To pay the entire mortgage off making monthly payments for 30 years would cost you $479,016.00.
The 2 1/2-point mortgage, which amounts to a $205,000 mortgage at 6% over 30 years would only require a $1,229.08 monthly payment. To pay this mortgage in full by making monthly payments for 30 years would end up costing you $442,468.80.
As you can easily see, if you were looking for a mortgage for the long haul, the 2 1/2-point, 6% mortgage would be the way to go. Your required payment would be less by a little over $100.00 each month and after the entire mortgage was paid 30 years later, you would have saved $36,547.20.
So, it looks like a no-brainier, you should go with the lower interest rate mortgage every time. Right? Well, not every time. What if you intended to sell this property very soon for a quick profit, a technique known as flipping?
If you only owned the property for a few months and only made a total of 2 payments on it, you would not have paid off any principle to speak of. So, with the profit you made from selling your property, by taking the 2 1/2-point mortgage, you would be paying off the $205,000 at closing.
You wouldn't have to pay the extra $5,000 if you had taken the no-point mortgage and so at closing, you would be paying $200,000. Hence, more profit for you!
If you were in the business of buying fixer-uppers and living in them while renovating them, you probably would be selling the property in less than 3 years. Sometimes you wouldn't need to hold the property for anywhere near 3 years. In a case like this, the 7% 0-point mortgage would be the more cost effective mortgage for you.
If you sold the property in 3 years exactly, neither mortgage would be a clear-cut money saver. At closing, you would owe $3,518.41 more on the 6% 2 1/2-point mortgage but you would have paid about $3,600 less in monthly payments because, as you'll remember, the 7% no-point mortgage has a monthly payment that is about $100.00 higher.
What might swing the advantage to the 7% mortgage in this case, is that the interest portion of your monthly payments are tax deductible. So, since the 7% mortgage requires more interest be paid, you would have a somewhat larger tax deduction.
The logical conclusion is, if you are getting a mortgage that you are sure you will only need for a short time, try to get a 0-point mortgage. If you are going to have the mortgage for a long time, the lower interest rate is definitely the way to go.
The break-even point between 0-point and 2 1/2-point mortgages used to be at about 5 years. Now, in this lower interest rate environment, it is more like 3 years.
If you are intending to keep a mortgage for 3 to 5 years, the only way you would know for certain which would be the better choice would be to know how long you will need the mortgage for and then look at the proposed mortgages' amortization tables.
There is one last word of caution. If you have decided that you will only need the mortgage for a short time and therefore intend to take the 0-point mortgage, make sure you will have no problem paying the higher monthly payment on time. Paying a $50.00 monthly late charge every month will throw all the calculations off as well as risk your good credit rating.
Also, be very sure you are getting a mortgage that doesn't have a pre-payment penalty. A pre-payment penalty would mess up the whole deal altogether.