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What’s the Point of Paying Points?

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You’re ready to buy a home. Or maybe you want to refinance your existing mortgage loan. As a member or veteran of the U.S. military, you are applying for a mortgage loan insured by the U.S. Department of Veterans Affairs, also known as a VA loan.

But when you talk to mortgage lenders, they ask if you want to purchase discount points. Paying for these points, lenders say, lets you reduce the interest rate that you’ll be charged on your loan, which also reduces your monthly mortgage payment.

Should you take this offer? Or should you pass on these discount points?

The short answer: You should probably pass, at least today. Mortgage interest rates are already so low now, especially with VA loans, that it rarely makes sense to pay for an even lower one.

“I know people are worried about mortgage interest rates going up,” said Michael Foguth, founder of Foguth Financial Group in Brighton, Mich. “But you still have rates today that are historically low. You can lock these rates in for 30 years if you want. [Some homeowners will] be telling your grandkids that you bought your house for an interest rate under 4%. They won’t believe you.”

Michael Hausam, a real estate agent and mortgage broker with Irvine, Calif.-based Shore Capital Corporation, said that buying discount points pays off even less frequently with VA loans. That’s because VA loans typically come with interest rates that are about a quarter percent lower than those attached to conventional mortgages.

At the same time, most of the VA borrowers with whom Hausam works are trying to put as little of their own cash into closing their loans as possible.

“The veterans try to close their purchase transactions with as little money out of pocket as possible,” Hausam said. “If that’s the case, then they are definitely not paying for discount points.”

But there are exceptions, depending on how long you plan on living in your home. Mortgage lenders, though, say that these exceptions truly are rare, and that paying for points on a VA loan today hardly makes financial sense.

The VA loan difference

A VA loan ranks as one of the most attractive mortgage types available. That’s because of one big feature: It requires no down payment.

VA loans also don’t require that borrowers pay mortgage insurance, another savings. Borrowers must pay mortgage insurance on conventional mortgages — those not insured by a government organization — if they don’t come up with a down payment of at least 20% of a home’s final cost.

There is, though, a funding fee for VA loans. The fee can vary, but for veterans and active-duty members of the U.S. Military, the funding fee for purchase loans is 2.15% of the loan amount.

The trade-off, though, is that VA loans are only available to a limited number of buyers. You must be an active-duty member or veteran of the U.S. Armed Forces, Reserves or National Guard. You can also qualify for one of these loans if you are the surviving spouse – who has not remarried – of a deceased veteran.

If you do qualify, a VA loan is an appealing option. You’ll still have to shop around, though, to find the lowest interest rates, as VA loans are originated by private mortgage lenders, not the U.S. Department of Veterans Affairs, which only insures these mortgages.

That’s where discount points come in: When you’re shopping around for a VA loan, your lender might ask if you want to buy down your interest rate to a lower level by purchasing discount points. You’ll have to determine if these points are worth it, and that usually depends on how long you plan on remaining in your home.
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How VA discount points work for purchase loans

When you apply for a new VA purchase loan, you have the option to pay for discount points to lower your mortgage interest rate. Usually, if you pay for one discount point at closing, you’ll lower your mortgage rate by 25 basis points or 0.25%.

For example, if your interest rate without points is 4.5%, you could lower that rate to 4.25% by paying for one VA discount point.

Discount points aren’t cheap. They cost 1% of your loan amount. If you are taking out a big mortgage, then, the discount points on your VA loan could cost thousands of dollars. Say you are taking out a VA loan for $200,000. One discount point costs $2,000, or 1% of your loan amount. Two discount points would cost $4,000.

You can also pay for partial points. On that same $200,000 VA loan, 0.5 discount points would cost you $1,000.

For a purchase loan, borrowers can pay for as many VA discount points as they want. The Department of Veterans Affairs does not put a limit on VA points for purchase mortgages as long as the number of points is “reasonable.”

The key, though, is to make sure you are not overpaying for what might be just a small dip in your monthly mortgage payments and overall savings.

Discount points and IRRLLs

You can buy points, too, when you are refinancing an existing VA loan.

The Department of Veterans Affairs gives refinancing their own name called interest rate reduction refinancing loans, or IRRRLs. An IRRRL is any VA-insured mortgage loan originated to replace an existing VA loan. You would typically take on an IRRRL as a way to get a new VA loan with a lower monthly interest rate.

An IRRRL is an attractive mortgage product, too, mostly because lenders usually aren’t required to perform an appraisal, check homeowners’ credit or underwrite the refinance.

The big requirements? You must be refinancing an existing VA loan. And the new interest rate with an IRRRL must be lower than the one attached to the original loan, unless borrowers are refinancing with the goal of moving from an adjustable-rate mortgage to a fixed-rate mortgage.

For the most part, the principal and interest payments with an IRRRL must be lower, too. However, there are three exceptions: the borrowers are refinancing out of an adjustable-rate mortgage, refinancing to a loan with a shorter term or  including the cost of energy-efficiency improvements with the IRRRL.

The veterans department does allow borrowers to pay for discount points when closing an IRRRL. But there are limits — borrowers can only buy a maximum of two points during an IRRRL.

For an IRRRL that would have a new balance of $100,000, then, with each point costing 1% of the loan amount, borrowers can only pay a maximum of $2,000 for two discount points.

Origination fee vs. discount points

It’s important to remember that your origination fee is not the same as discount points, Foguth said.

The origination fee is what your lender charges you to close a mortgage loan. Lenders themselves make this confusing: Some advertise their origination fees as points, Foguth said. They’ll say they charge two points, for example, to originate a loan.

As with discount points, origination points typically equal 1% of a loan. For a mortgage of $200,000, then, a lender advertising an origination fee of two points is charging a fee of $4,000. This fee, though, is different than points.

The bottom line: Should you buy discount points?

In most cases, discount points don’t make sense today, Foguth said, simply because interest rates are so low. Homeowners would have to live in their residences for too long for the monthly savings from an interest rate reduction to pay for the money they spend on points.

Foguth has a point. As of the week ending June 7, the average interest rate lenders were charging on a 30-year fixed-rate mortgage was 4.54%, according to the Freddie Mac Primary Mortgage Market Survey. The average rate on a 15-year fixed-rate mortgage stood at 4.06%.

This is up from the beginning of the year, where the average rate on a 30-year fixed-rate loan was 3.98% and the average on a 15-year was 3.38%. But it’s still low considering that at the end of May of 2008, the average interest rate on a 30-year, fixed-rate loan was 6.08%, according to Freddie Mac.

Adam P. Smith, president and founder of the Colorado Real Estate Finance Group in Greenwood Village, Colo., said that timing matters when determining whether it makes sense to buy discount points. In general, the longer you stay in your home, the more likely it is that buying points to reduce your interest rate will save you money.

If you plan on living in your home for a shorter number of years, usually five or less? The odds are high that you won’t recoup the costs of discount points, Smith said.

Say you are taking out a 30-year fixed-rate mortgage loan of $200,000 and your rate without paying for discount points is 4.56%. If you buy two points to reduce your interest rate to 4.06% at a cost of $4,000, it would take you 68 months, or more than five years, to break even. After you hit that 68-month mark, you’ll save money because of your points.

Buying points, then, could pay off if you plan on living in your home for a long enough time. The problem is, many homeowners think they are going to live in their home for 20 years but then move after a far shorter time anyway, Smith said. Others refinance their existing mortgage loans before they reach the points break-even point. In such cases, buying points is not a financially smart move.

Hausam gives this example: Say you take out a mortgage loan for $100,000 and your interest rate without discount points is 4.25%. That monthly mortgage payment — not including property taxes or homeowners insurance — would be $14.52 more a month than if you paid $1,000 to buy a discount point to lower your interest rate to 4%.

Is that worth it? Hausam said it depends on whether you’re more interested in having the lowest possible monthly payment or if you’d rather pay as little in upfront costs to close your mortgage. What’s more important, that $1,000 in cash that you don’t spend, or the about $14 a month savings?

If you stay in your home long enough, or you don’t refinance to a new mortgage anytime soon, the monthly savings might pay off. But Hausam said no matter how big your mortgage is, or no matter what the interest rate, you’ll always need to wait five or six years to hit the break-even point when buying discount points.

“And that’s the rule of thumb whether it’s a $7 million loan or a $75,000 loan,” he said.


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