Discount Points and/or origination fees are just a cost of credit. There is an inverse relationship between the retail rate a consumer receives and the upfront costs she pays. Let's look at today's mortgage rates and compare the costs associated with a $200,000 loan amount. We'll assume that the third-party closing costs are about $2,000.
- A borrower could get a 4.875% rate for 1 point ($2,000) or a total of $4,000 in closing costs. Let's assume those costs will be added to the remaining loan balance and that the new loan balance will be $204,000.
- A borrower could get a 5.250% rate for 0 points ($0) or a total of $2,000 in closing costs. Let's assume those costs will be added to the remaining loan balance and that the new loan balance will be $202,000.
Which loan solution makes more sense? The answer lies in the expected hold time of the home. This particular borrower announced that she would own the home "forever". I consider "forever" to be a 7-year hold. Seven years because the kids grow, neighborhoods change, houses become too big or too small, or a change in employment might promulgate a move.
The proper way to compare these two loan solutions is to run amortization tables for each one.
- Solution #1 is a $204,000 loan, for 30 years, at 4.875%. When we run the amortization schedule, we see that the payment is $1,080 and the remaining loan balance, in February, 2016, will be $178,595.
- Solution #2 is a $202,000 loan, for 30 years, at 5.250%. When we run the amortization schedule, we see that the payment is $1,131, and the remaining loan balance, in February, 2016, will be $178,540.
A wash, huh? In this case, it seems like accepting the higher interest rate makes sense...ONLY if you plan on moving in the next 7 years. Let's take it out to twelve years.
- Solution #1: Loan balance is $154,595
- Solution #2: Loan balance is $155,657
Still a wash.
Is the current rate/points relationship always a good rule of thumb? Hardly. Rate tables change 2-3 times a day in this volatile mortgage market. The best advice is to find a mortgage adviser who follows the mortgage-backed securities market like a hawk so that you can try to lock-in your refinance rate when rates are low and lay off the market as rates rise.
A sharp loan adviser will perform this snap analysis for you BEFORE he calls you to lock-in the rate. Sometimes, the market rewards those who pays the discount point, sometimes it doesn't. That changes 2-3 times daily, as well.
MORAL: There is no rule-of-thumb in this volatile market. Rate/Cost/Benefit analysis is dynamic. If your bank rep isn't discussing this with you, you're talking to the wrong guy.
