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 your new 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 you want to borrow at a rate below the bond market’s desired yield (changing minute-by-minute in global markets for capital), 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 6.00%, and you are determined to pay no more than 5.875%, 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 5.875% 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 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. (Note: regulatory changes in the aftermath of the Great Credit Bubble may cause a return of fractional origination fees in place of some “junk” charges, like documents, processing, or underwriting.)
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, or omitted from advertising.
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, or vice-versa.
Ask your banker to quote total points. Any fee charged as a percent of the loan amount is a point, and is present in the deal to buy down the interest rate.
Having defined terms, is paying points a good deal?
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 one-eighth (.125%) in rate usually costs .50% in point ($500). Each eighth in rate amortizes to about $8.00 per month (at 6.00%). If you divide the monthly benefit ($8.00) into the cost ($500), you get the number of months it takes to recapture the fee you paid. In this example, 62.5 months; but really closer to six years because you paid the fee in 2010 dollars, and 62.5 months hence, eight bucks won’t be worth eight bucks. If you sell or refinance in less than six years, you leave money on the table.
Refinance note: points and origination are deductible in the year paid for purchase loans, but in refis deductible pro rata over the remaining life of the loan. In the example above, the fee and the interest payment are equally deductible; in a refi the altered deductibility takes fee-paying recapture out to seven or eight years.
This inevitable point versus rate relationship is one of Wall Street’s great self-fulfilling prophecies. In the 75 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.