Points, rates, and closing costs

In short

A friend of mine once signed his mortgage papers so fast he never saw the fee page. You can do better than that, and it takes about an hour. Ask every lender for the same thing, a written Loan Estimate, so you can set the offers side by side. Look at the interest rate, but also look at the points and the closing costs, because all three shape what you pay. Work out how long you plan to keep the loan before you pay any points. Then divide the extra cost by the monthly savings to find your break even point. Shopping around is the one step that costs nothing and can save real money.

The whole of it

What it is

I once watched a neighbor haggle over the price of a used truck for an hour, then shrug and accept a mortgage on the first offer he got. Many of us have done something like that. A mortgage feels too big to question, and the paperwork looks too thick to read. But three pieces of it are worth your time, and each one is simpler than it looks.

The interest rate is the price of borrowing the money, shown as a yearly percent. Points are fees you pay the lender at closing, and one point equals one percent of the loan amount. Some points buy a lower rate. These are often called discount points. Other points are just a fee for making the loan. Closing costs are the whole bundle of charges due when the loan is finalized, and they include the lender's fees, the appraisal, title work, and prepaid items like the first bit of insurance and taxes.

You are not foolish for finding this confusing. The words are odd, and the system was not built with you in mind. Still, you can learn it.

How it works

A friend of mine likes to say that a lower rate is never free. She is right. When a lender offers a lower rate, it often asks for something in return, and that something is points paid up front. You pay more now to pay less each month. That trade is called buying down the rate.

The other side of the coin also exists. A lender may offer a lender credit. That means the lender pays part of your closing costs, and in return you accept a somewhat higher rate. You pay less now and more each month.

So you are always choosing between paying now and paying later. Neither choice is wrong. The right one depends on how long you will keep the loan. A shorter stay gives points less time to pay you back, and a longer stay gives them more. Your own plans decide which side you land on.

You have probably heard that the rate is the number that matters. It matters, but it is not the whole story. Two loans with the same rate can carry very different fees. That is why the Loan Estimate exists. It is a standard three page form that lenders must give you within three business days after you apply. The Consumer Financial Protection Bureau explains this form on its website, and it is worth a read before you apply.

The numbers, and where to find yours

If you are holding a Loan Estimate, turn to page two. That page lists your closing costs in sections. Lender charges sit in one section, and third party services such as the appraisal and title work sit in another. Points show up on the first page of the form as well as within the lender charges. Look for a line called points or discount points, shown as a percent of the loan and as a dollar amount.

Page three has a comparison section. It shows the total you will have paid in principal, interest, mortgage insurance, and loan costs after five years. It also shows your annual percentage rate, or APR, which folds many of the fees into a single yearly figure. The APR helps you compare offers, but it assumes you keep the loan for its full term, so it can mislead you if you plan to move sooner.

Some numbers are set by law or by program rules and change over time. If you use an FHA loan, the upfront mortgage insurance premium is the current figure, which the official source publishes each year of the loan amount, and the site will show the current figure with its source. For a VA loan, the funding fee depends on your down payment and service history, and the current schedule is the current figure, which the official source publishes each year. The federal agencies publish these on their own pages, and those pages are the ones to trust.

Your own numbers live on your Loan Estimate and, three days before closing, on your Closing Disclosure. Put the two side by side. The fees should match closely. If they do not, ask why.

A worked example

Let me tell you about a woman named Maria. She is buying a home and needs a loan of 300,000 dollars. Her lender gives her two choices.

The first choice is a rate of 6.50 percent with no points. The second is a rate of 6.25 percent with one point.

One point costs 1 percent of 300,000 dollars. That is 300,000 times 0.01, which equals 3,000 dollars.

Now for the monthly payments. On a 30 year loan, the payment at 6.50 percent works out to about 1,896 dollars a month. At 6.25 percent, it works out to about 1,847 dollars a month. Those figures come from the standard loan payment formula, and any free online calculator will give you the same. The difference is 1,896 minus 1,847, which equals 49 dollars a month.

Here is the break even math. Divide the cost of the point by the monthly savings. That is 3,000 divided by 49, which equals about 61 months. That is a little over five years.

So the math says Maria would need to keep this loan for about 61 months before the point pays her back. Say she keeps it for 36 months. She would have paid 3,000 dollars and saved 49 times 36, which is 1,764 dollars. Say she keeps it for 120 months. She would have saved 49 times 120, which is 5,880 dollars, and 5,880 minus 3,000 leaves 2,880 dollars ahead.

Maria thought about her own plans, and she chose the option that fit them. Her friend Dale weighed the same two loans against his own plans and made his own choice. Same loan, different people, different answers.

Where it goes wrong

I have seen good people get tripped up here, and it is never because they lacked sense. It is because nobody slowed the process down for them.

One trap is judging by the rate alone. A low rate with heavy fees can cost more than a slightly higher rate with light ones. Another is paying points on a loan you will not keep. If you might refinance or sell soon, the break even point may never arrive.

A third trap is cash. Points and closing costs come out of your pocket at the table, and money spent there is money you cannot use as a down payment or as a cushion afterward. Be careful not to drain your savings to shave a small amount off the payment.

Watch also for fees that were not on the first estimate. Some charges are allowed to change and some are not, and the CFPB explains which are which on its website. If a number jumps, ask questions. You are the customer, and a fair lender will explain.

Last, do not let the rush of closing day push you. You have the right to see your Closing Disclosure three business days before you sign. Use that time.

Questions to answer before you leave this page

How long do I honestly expect to live in this home, and what would change that plan? Do I have my Loan Estimates from at least three lenders in front of me, and have I compared points, rates, and total closing costs on each? If I paid a point, how many months would it take to earn the cost back, and does that fit my plans? Will paying for points or closing costs leave me with enough savings to handle a broken water heater or a lost paycheck? Have I asked each lender which fees could still change before closing? And have I set aside an hour to read every line of my Closing Disclosure before I sign?