Points & Mortgages: Good idea or wasted money? Observations from a LO – #3 in a series.

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Warning this post is long, technical, & full of numbers!
Understanding points takes a few more words than most of us want to read.

Mortgages are not the most exciting topic on the planet.  I try to keep my posts relatively short and to the point.  If you are considering discount points for a mortgage – give this post a read.  If you don’t want to read it – give me a call or send me a note.

If you have insomnia – I recommend this blog and a smart phone as you try to go to sleep.

Virtually every mortgage transaction includes a discussion of discount points.  Candidly, points are confusing.  From time to time, I will hear good analysis on points but most of the time I find the analysis misguided.

 Michael Nelson, Equity PrimeUse the right tool, in the right amount, for the right purpose

Points are like an ice cream scoop.  If you use the ice cream scoop a few times a week to scoop your favorite bowl of ice cream, the scoop is a great tool.  If you use that scoop 5 times a day for the next year it will bury you in debt – I mean ice cream. 

 

 

Let’s start at the beginning – with a definition.  This definition comes to us from Investopedia along with an article they penned on the topic.

Discount points are a type of fee mortgage borrowers can purchase that lowers the amount of interest they will have to pay on subsequent payments. Each point generally costs 1% of the total loan amount and depending on the borrower, each point lowers your interest rate by one-eighth to one one-quarter of your interest rate. Discount points are tax deductible in the year in which they are paid.

Discount points are an ancillary cost to the mortgage

Approved MortgageBy definition, the mortgage is approved at a higher interest rate – a rate that does not include  the cost of the discount. Analyze the cost of the discount points as a separate line item to the cost of the mortgage.  The mortgage is approved with or without the discount – this is important.  Because the points are not required, analyze the cost of the discount versus the opportunity cost of retiring other high interest debt (such as credit cards, cars, etc).
Okay – we have a definition and a few of  my editorial comments.  Let’s use the example below to provide clarity regarding discount points.
 
Example:
  • The borrower is approved for a $100,000 30 year fixed rate mortgage @ 5%.  
  • The lender will discount the rate by 25 bps (basis points) to 4.75%.  
  • This discount will cost one point (1%) which is $1,000.  

What is the best option for the borrower – 5% or 4.75%?

 Please refer to the tables below.  The tables below contain the math central to our discussion.  This analysis includes principal and interest only.  Tax and insurance is not included.  Tax and insurance will be the same for each loan.

Table 1: Monthly Mortgage Payment and Break Even Analysis

5% 4.75% Difference Break Even – Months Break Even – Years
$537 $527 $10 100 8.4
 As you can see in the table, the difference in the monthly payment is $10.00. Is the $10.00 difference in monthly payment worth the up front $1,000?  The answer, of course, is – it depends.  The borrower must consider how long they intend to own the home.

How long the customer stays in the house or re-finances ultimately determines if a discount is worth the cost!

 michael nelson equity primeMost borrowers and lenders will immediately conduct a break-even analysis to determine the benefit of the discount.  In this example, the $10 difference in monthly payment is recouped in 100 months or 8.4 years.  The borrower then considers how long they will live in the house – if it is more than 8 years the discount seems like a good deal.
 
While the break even analysis is certainly important, it provides a small piece of the analysis required for this borrower.  Because interest is calculated monthly on the remaining balance of a loan, the interest paid in the initial years of a mortgage is significantly greater than the principal.  In fact, you can expect to pay between 60 and 75% of the total interest payment for a 30 year mortgage in the first 15 years.
 
Thus the break even analysis includes a flawed assumption – that the $10 monthly savings in payment repays the $1,000 cost dollar for dollar.  Remember, the $1,000 discount is financed at a rate of 4.75%. Because of the interest rate, the $10 savings does not pay back the original $1,000 over 100 months.
 
Let’s now take the analysis a bit further by looking at the total interest and principal paid over the first 5, 10, and 15 years.  
To begin this analysis we first need to calculate principal amount financed.  In most cases the borrower will finance the discount points into the balance of the loan (more discussion on this later).  Therefore, the 5% principal balance is $100,000 and the principal balance of the discounted loan is $101,000.  

Table 2: Total Mortgage Interest Paid @ 5, 10, & 15 Years

Term 5% Loan 4.75% Loan Difference
5 Years $24,038 $23,025 -$1,013
10 Years $45,761 $43,753 -$2,007
15 Years $64,512 $61,570 -$2,941
 In the first 5 years of the 5% loan the borrower will pay just over $24,000 of interest versus approximately $23,000 for the 4.75% loan – a difference of $1,013 in favor of the borrower.  Wow – that seems a lot better than recouping the $1,000 over 8 years – the conclusion of the break-even analysis.  This is a no-brainer spend – the $1,000.
 
Not so fast – let’s remember we financed the $1,000 and added that amount to the principal balance of the 4.75% loan. Remember also, interest comprises most of the payment in the initial years of a loan.  
Now let’s take a look at how much equity we have in the home for each loan.
 
The goal of every mortgage is to pay the least amount of interest possible to generate the most equity.  Equity is the borrower’s ownership amount in the house.  In a 30 year fixed mortgage, equity increases with each payment.  Which brings us to Table 3.

Table 3: Mortgage Principal Remaining @ 5, 10, 15 Years

Term 5% 4.75% Difference
5 Years $91,829 $92,413 -$584
10 Years $81,342 $80,530 $812
15 Years $67,884 $66,735 $1,149
In the first 5 years the borrower actually has more equity in the home with the 5% loan than the 4.75% loan.  This equity trend will reverse as the loan matures. After 15 years, the lower interest rate will dramatically improve the equity position more quickly than the 5% loan.
 

The average 30 year fixed loan in the US is refinanced every 7 years.

 refianceSo what is the conclusion?
Our example assumes that the average borrower has no other debt at an interest rate greater than 5% – as you can guess this is not true for virtually every borrower.  Credit cards are usually between 13 and 20%.  If the borrower in this example has debt at over 5% and there is a reasonable chance that they will refinance or move between 7 -10 years, the best financial decision is to take the 5% interest rate and use $1,000 to pay down other debt at higher interest rates.  
 
However, if the borrower believes they will be in the house more than 10 years they should give strong consideration to paying the discount on the rate with cash and not financing into the mortgage.  After 10 to 15 years the discounted interest rate is better for the borrower.
 
Please keep in mind, this analysis does not include the tax benefit of the mortgage.  In the first few years, the tax advantage of a mortgage also favors the 5% loan.  This changes overtime.  It is important to consultant with financial advisors and a CPA for the complete tax implications of this example.
 

Work with a lender who can do the math!

 maths-problems-marilyn-ftrIf you are working with a lender that does not understand this example, you are working with the wrong lender.  It is the responsibility of the lender to calculate the implications of discounts.  You need to find another lender if they can’t do this math or answer your questions.
 
Finally, remember this!  Lenders are not giving discounts because they save you money at their expense.  The lenders are doing sophisticated calculations determining the risk of discounting rates over the lifespan of a whole portfolio of loans.  Lenders know how many discounted loans are refinanced in the first few years (good for them) and how many are going to term (good for the borrower).  Lenders will price accordingly – just make sure you as a borrower have done the analysis to know which scenario is best for your situation.
Please call, e-mail, text, or Skype with comments or questions.  I enjoy the dialogue!
As always Happy House Hunting!
Mike
Michael F Nelson
720.213.6260
mnelson@equityprime.com
@michaelfnelson2
Skype: michael.nelson2014
NMLS: 1314188
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