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Zero Point Loans -- "The Pros and Cons"by Wayne RepichOne of the most confusing areas for consumers in a mortgage loan transaction are 'points'. In this article, I'll explain the correlation of points and interest rates and the advantages and disadvantages of zero point loans. A 'point' is equal to a percent of the loan amount; one point on a $200,000 loan equals one percent of $200,000, or $2,000. Points are a term used for the loan origination fee. A simple rule to remember is that the higher the points, the lower the rate. For example, this loan may have the following point and rate combinations:
In this example, the 2 points or $4,000 is used to reduce the rate of 7.50% by one-half of one percent. 'Points' can also be called "yield equivilant fees". Does it make sense to pay points? The simple answer is ... it depends. There are many factors to consider and one of the primary items to review is the overall long term cost of a zero-point loan versus a loan with points. One easy way to determine the value of the 2 point loan is to determine how many months (or payments) it will take to recoup the original 2 points. To do that, divide the cost of the points ($4,000) by the difference in the payment ($67.83) to arrive at the number of months it will take for the points to pay for themselves. In this example, it would take 58.97 months to recover the initial cost of the points. Let's look at our two combinations and see how they perform over 7 years:
The net difference is calculated by adding the difference of the principal balances ($1,372.65) to the number of months after the break-even point (84 months minus 58.97 = 25.03) times the difference in payments ($67.83 or $1,697.78). In this example, Combination B would outperform Combination A by $3,070.43. The above equation is a simple approach to compare the difference between a 0 cost loan and loan with points. However, there can be other considerations. For instance, some consumers may try to calculate tax implications of the different amount of points and interest paid and the subsequent tax deductions. Other borrowers may consider the present 'value' of the dollar versus the future 'value', the loss of opportunity of being able to invest the $4,000 or corresponding yields of such investment. I don't believe that it's necessary to go into that much detail, and am confident that the great majority of consumers will be able to determine the advantages or disadvantages of a zero-point loan by using the above scenario. Some other thoughts to consider. The above formula works well with a fixed rate loan, but not with an adjustable rate mortgage (ARM). One reason is that the interest rate on ARMs will likely adjust in 6 or 12 months and little benefit will be derived from buying down the initial rate. Points can be used to buy the margin down on ARMS, creating a lower monthly payment. I hope this article has helped you to understand the varied measures used to determine the advantages and disadvantages of zero-point loans. Each borrower is different, and the evaluations must be made on a case-by-case basis. As you can see, there are many factors to consider when looking at the available options. Your professional mortgage advisor should be able to answer all of your questions, outline the costs and benefits, and even give you a few new ones to consider! |
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