Factors that Affect Mortgage Rates – Points and Fees

The relationship between your mortgage rate and its costs is an inverse one – the lower your rate, the higher the fees. The mortgage with the lower rate is the better or more desirable product, so it makes sense that it costs more. But how do you know if the lower rate is a screaming bargain or an overpriced mistake? More…

How points and fees affect your mortgage rate, continued…

Suppose you contact several mortgage lenders and are given these quotes for a $100,000 30-year fixed-rate home loan:

  • 4.125 percent rate costing nothing
  • 4.000 percent rate costing 1 percent of the loan amount
  • 3.75 percent rate costing 2 percent
  • 3.625 percent rate costing 3 percent

You can see that the lower the rate, the higher the costs. But which loan is the better deal? The loan’s annual percentage rate, or APR, is helpful when you shop for home loans. It “equalizes” loans with various pricing and rates, using mathematical formulas. A loan’s APR includes not just its interest rate but also its costs.

What’s the point of points?

In addition to your ordinary lender fees, you can choose to pay points to get a lower interest rate. This is called “buying down” your mortgage rate. It only makes sense to pay points when the benefit that you receive (the lower mortgage rate and payment) exceeds the added upfront cost. One way of measuring this is by comparing the annual percentage rates of each mortgage quote.

How APR works

If you borrow $100,000 at four percent, your payment is $477. If, however, it costs you one percent of the loan amount to get the loan, you’re really paying $477 a month for only $99,000. In that case, the rate for a $99,000 loan with a $477 a month payment is 4.08 percent. That’s your APR. So, here are the APRs and payments of the four loans in our comparison:

Rate Costs (percent of loan amount) Payment APR
4.125% 0 $488.65 4.125%
4.000% 1 $477.42 4.083%
3.750% 2 $463.12 3.916%
3.625% 3 $456.05 3.874%

So, the 3.625 percent loan costing three points has the lowest APR. Does that mean paying three points is always better than paying no points? Only if you keep your loan for the full 30-year term.

Break-even analysis for costs

You’ll also consider how long it will take for your monthly savings to pay for the cost of buying down your mortgage rate. In this case, the loan costing three percent, or $3,000, comes with a payment that is $28.60 less than the payment of the zero-cost loan. By simply dividing the $3,000 cost by the $28.60 savings, you get 105 months (8 years and 9 months). That means that it will take you nearly nine years before your savings outstrips the extra loan costs.

Your time frame affects the APR

Whenever you pay upfront costs to get a mortgage, the APR calculation assumes that you spread those costs out over the full term of the mortgage. However, if you don’t keep the loan for its entire term, the APR disclosed as required by law is inaccurate. That’s because the cost of the loan is collected upfront, but your savings over time depend on the number of months that you receive your lower payment. For each timeframe, the least-expensive program is highlighted in red:

5 Yrs 10 Yrs 15Yrs 25Yrs 30Yrs
4.125% 4.125% 4.125% 4.125% 4.125%
4.407% 4.212% 4.147% 4.095% 4.083%
4.559% 4.172% 4.041% 3.938% 3.916%
4.834% 4.254% 4.059% 3.904% 3.874%

The graph below shows you how different timeframes determine which of the four loan choices is best.For shorter timeframes, the loan with no upfront costs is the clear winner, even though the mortgage rate (and payment) is higher. But the longer you keep the loan, the better the most expensive loan performs.

What if you don’t know how long you’ll keep your mortgage?

That’s a good question. Few people keep their mortgages for their entire terms. They refinance their loans or sell their homes. How often, on average, do homeowners keep their houses? Longer than they used to -- perhaps because of falling property values between 2008 and 2012. In any event, the median number of years in a home in the US has increased from about six years in 2008 to nine years in 2012, according to the National Association of Realtors.

You can use that figure for some guidance, adjusting it upward if you’re well-established and middle-aged, or reducing it if you’re young, and making career and family changes, or if you’re older and expect to downsize in the near future.

If you’re completely in doubt, you’ll probably want to choose the mortgage with the fewest upfront costs.

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