In his weekly column, Central Coast Lending co-owner and broker Jason Grote takes a look at interest rates and expands on the question – should I pay the points for a lower rate?
With interest rates continuing to fall and lower and lower rates becoming available, I often hear the question: should I pay extra points for a lower rate? The issue is this: every interest rate has a cost (points) associated with it. The lower rates may now be available, but they may have a high cost associated with them. Today, I will give you an example to help you determine a course of action in this Rate vs. Points debate.
The following scenario is based loosely on interest rates and fees available today, but should be used for illustrative purposes only. Some numbers are rounded for ease of understanding. This scenario is based on a $400,000 loan amount for a refinance transaction.
First we must understand the third party fees that this and all loans are subject to. They are:
-Title and Escrow Fees: $1325*
-Bank Fees: $950*
-Appraisal Fees: $450*
*These are averages of major companies based on our loan amount
This means that the third party fees for this loan total $2,725. We will revisit this number momentarily.
Now, each interest rate has a fee associated with it. We call this fee “points.” For example,
3.625% costs 1% (or one point)… in our $400,000 example, 1% is $4,000.
3.75% costs .25% (or a quarter of a point)… in our $400,000 example, .25% is $1,000
3.875% is a -.625% credit for closing cost (negative points to offset closing costs)… in our $400,000 example, -.625% is -$2,500 %
Stay with me here.
If you choose 3.625% on our example $400,000 loan, you will pay third party fees of $2,725 + points of $4,000 for a total cost of $6,725
If you choose 3.75% on our example $400,000 loan, you will pay third party fees of $2,725 + points of $1,000 for a total cost of $3,725
If you choose 3.875% on our example $400,000 loan, you will pay third party fees of $2,725 and receive closing cost credit (negative points) of $-2,500 for a total cost of $225.
3.625% costs $6,725
3.750% costs $3,725
3.875% costs $225
Now we need to take it a step farther. Which is the right choice? Is cheapest best?
$400,000 at 3.625% has a monthly payment of $1,824.21
$400,000 at 3.750% has a monthly payment of $1,852.46
$400,000 at 3.875% has a monthly payment of $1,880.95
Now let’s refocus. This is a refinance. So now we see the cost options, how do we know which is best?
Let’s say that our hypothetical borrower’s $400,000 loan has a 4.5% interest rate. If this was originally $440,000 loan, then the monthly payment is $2,229.41.
Refinancing to 3.625% would save $405.20 per month, but the rate cost $6,725. It will take 16.59 months of saving $405.20 per month to recuperate the $6,725 cost of refinancing.
Refinancing to 3.750% would save $376.95 per month, but the rate cost $3,725. It will take 9.88 months of saving $376.95 per month to recuperate the $3,725 cost of refinancing.
Refinancing to 3.875% would save $348.46 per month, but the rate cost $225. It will take less than 1 month of saving $348.46 per month to recuperate the $225 cost of refinancing.
So do you pay points? You do if you plan being in the house more than 17 months!
Oh and by the way, this example gives us a response to the adage “it is not worth it to refinance if you can’t drop your interest rate a whole point.” With these savings available, I have proven that you don’t need to save a full point in percentage for it to make sense to refinance. As you can see, the wisdom of refinance depends more on the cost than the rate.
Stay tuned for my next installment, in which I will discuss the opportunity for this borrower to reduce his or her term to 20 or even 15 years.
– Jason Grote (805.441.1016)