By Rae Oakley, Flyhomes Mortgage
If you’re like me, then you like having options. In today’s mortgage world, you have a lot of options as a borrower. One of those options is whether to select an interest rate that comes with points or one that comes with credits.
Points and credits
Paying points means paying a one-time fee at closing in exchange for a lower interest rate on your loan.
On the other hand, taking a credit means lowering your costs at closing in exchange for a slightly higher interest rate.
What this means is that by paying points, you’ll see greater savings over the life of your loan, whereas by taking credits, you’ll see the greatest amount of savings at the beginning of your loan.
So how do you know which one is right for you? One approach is to calculate the breakeven point.
The breakeven point
The breakeven point between two interest rates (one that comes with points and one that comes with credits) represents the moment in time when the two scenarios are more or less equal.
For example, let’s say you are taking out a $360,000 loan, and your loan officer offers you two interest rates for a 30 year fixed rate mortgage.
Option 1: Points
– 3.500% with $1,270 in points
– 1 point is 1% of your loan amount, so there might be some lenders who quote you points in a percentage format. In this case $1,270 in points is $1,270/$360,000 *100 = 0.35% or 0.35 points.
Option 2: Credits
– 3.625% with $1,530 in credits
To calculate the breakeven point, we will also need to know the monthly payments associated with the two interest rates.
Here is a simplified formula that we have found useful for calculating breakeven*.
Take the difference in lender credits and points, and divide that by the difference in monthly payments. Since this number is the breakeven point in months, we recommend dividing that by 12 to get the breakeven point in years.
In other words, at 7.3 years, the two options are equal in value.
If you know for sure that you’ll own in the home for fewer than 7.3 years, you might want to take the savings now and select the higher interest rate with the credit.
Similarly, if you know for sure that you’ll have the mortgage for longer than 7.3 years, you might take the lower interest rate and pay points, as you will see greater savings over the life of the loan.
Short term vs. long term goals
As an experiment, ask yourself: “Where was I five years ago? Did I think I would be here now?”
For most of us, this experiment highlights the difficulty we have forecasting our lives more than 5 years out. Acknowledging this difficulty can be helpful in determining what rate you might want to go with.
For context, most Americans will sell, refinance, or close their mortgage within 6 years of getting it.
Even if you don’t plan to physically be in the home for longer than 7.3 years, ask yourself another question: Is there a chance you’ll keep the home (perhaps as an investment property), and therefore have the mortgage for longer than 7 years?
In other words, just because you might not live in the home longer than the breakeven point doesn’t mean you won’t have the mortgage. There could be longer term goals you’ll want to factor in.
Similarly, consider the current market and your future goals for the mortgage. Will there come a time when you might want to refinance into a lower rate or shorter term? Or perhaps take cash out? Refinancing means getting a new mortgage to pay off your old one, so keep this in mind if you refinance before your breakeven point has passed.
Lastly, consider your short term financial goals. Do you need new furniture for the new home? Do you need a little extra cash on hand now? If so, that might be another way to decide whether an interest rate with credits makes sense for you. Receiving a credit lowers your closing costs and frees up cash for other uses like furniture, in-home repairs, or movers.
Still not sure? Reach out to Flyhomes Mortgage and any of our loan advisors will be able to help guide you through selecting your interest rate.
*This formula does not take into account the impact of amortization and generally overestimates the break even period by about 5-12 months.