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Brian Brady recently suggested that I explain how mortgage interest rates can be priced with or without a discount point since I’m now posting mortgage interest rates on Fridays here at RCG.

One point is one percent of the loan amount. Typically, but not always, **one point equals 0.25% in interest rate**. You may hear lenders refer to discount points or origination fees…for me, they’re one in the same. I’m paid eitiher way. If you’re a buyer shopping rates, look on the Good Faith Estimate for the origination fee and discount points and add them together. That’s how many points you’re paying to buy that interest rate for a certain period of time.

For example, if a 30 year fixed rate has a rate of 5.75% with paying 1 point, zero points would probably be 6.00%. Whether or not someone pays for a point should be decided by how soon they will break even on the point as it is a significant cost. A simple formula to determine when you break even is to divide the difference in payment between the 1 point and the 0 point scenario into the cost of the point paid. The scenario below is based on a loan amount of $400,000.

Rate: 5.75% based on 1 point = $4,000

Principle and interest payment: $2,334.29

Monthly savings over the 6% payment at zero points = $63.91

How long to break even on the $4000 =63 months

Rate: 6.000% based on 0 points = $0

Principle and interest payment: $2,398.20

If a borrower is planning on living in their home more than 5 years and not refinance during that time, then paying the point may be the right choice.

A borrower can also have their loan priced to pay their closing costs.

Rate: 6.125% = 0 points and approx. $2000 in rebate to cover closing costs (a.k.a. the “no cost mortgage

What a perfect explanation of discount points and how to properly plan your mortgage. Once again, you demonstrate why a homebuyer should consider an experienced loan advisor rather than the “in-house” loan hack.

Look for some references or trackbacks, Rhonda, in the near future.

“Bottom line, it’s important to know your options and to pick the pricing that works best for your financial goals. But hey, that’s just my opinion, right Brian? ”

an EXPERT opinion, Rhonda…and EXPERT opinion. Nice job.

Hi Rhonda,

Can you help me out? I’m unclear on this:

[You may hear lenders refer to discount points or origination fees…for me, they’re one in the same. I’m paid either way.]

I always thought discount points and a loan origination fee were two separate things.

Thanks.

Really …what’s the point? we have to asl ourselves this question everyday and every step…

I read your great article so I have to say …Thanks alot.

I wrote this post with the rate shoping public in mind…my goal was to really simplify this. Some LOs can talk discounts and origination fees so smooth and fast, you could feel like you’re playing the cap game at Safeco Field.

For example, Ima Shopper calls 3 lenders for quotes (hopefully at the same time and same day since rates change throughout the day sometimes…and Ima wouldn’t want to miss working with the best lender if she happened to call and make a decision on who to work with when rates are all ready different)…sorry…I’m back on my soapbox…I’ll get back to the example. Here are the quotes from the lender over the phone (GFE is hopefully emailed to Ima as well…but we know this doesn’t always happen since Ima doesn’t trust any LO and certainly doesn’t want them to have her email, fax or mailing address for the GFE/TIL or anything else the lender may have).

Ima: Hello, can you tell me what your rate is for a 30 year fixed rate mortgage?

L.O. 1): 6.00% with no discount fee. (L.O. 1 has priced the mortgage with 1% on the back from the lender…ysp/srp or it’s just built into the pricing). Cost to Ima in total points = 0.

L.O. 2): 6.00% with no discount fee. (L..O. 2 does charge an origination but does not explain the closing costs over the phone to Ima). Cost to Ima in total points = 1.

L.O. 3): 5.75% which will cost 1%…the 1% figure is 1% of the loan amount to the consumer if it’s called a discount point or origination fee (L.O. 3 is not being compensated 1% on the back). Cost to Ima in total points = 1.

L.O. 4): 5.625% whch will cost 1% orig. and 1.25% discount. Cost to Ima for a rate of 5.62% = 2.25 in total points.

Shoppers need to (1) ask what the total orig. and discount points are for the rate they’re being quoted (2) add up the orig. and discount together. That is basically what they’re paying for that rate.

I did say “they’re one in the same for me. This is how I’m paid”. My mortgage career has only been at one company and we are a Correspondent Lender (simply put, a combination between a bank and a broker). This is how I price my loans.

This is a grey area and a potentional danger zone for Ima Shoppers.

Which is why APR is required to be disclosed at the same time the rate is quoted in advertising.

Jillayne, when a shopper calls a lender for rates, do you think they’re being verbally told what the APR is?

Gahhhh!!!

Rhonda, you’re missing a key point when doing the math on the “payback” timeframe.

You divided $4,000 by $63.91 and got 63 months. This is correct. However, what you forgot to point out in your analysis is that the $63.91 delta between the 5.75% and 6.0% rate is tax deductible. If you’re in the 28% tax bracket, that $63.91 is effectively reduced to $46.02 after the tax deduction.

$4,000 divided by $46.02 is 87 months.

So the ‘real’ payback on the $4K is 87 months, not 63. BIG difference. Also, there are the lost opportunity costs on the $4k during that payback window.

Why is it that EVERY loan officer I’ve spoken to always misses this point when discussing the payback period? Are loan officers paid more for getting points on loans they sell?

Frankly, as far as I’m concerned, you’re almost always better off not paying any fees and closing costs. Most people either move, sell or refinance within 7 years. Using a zero cost loan, if the rates were to drop substantially in the next 2 years for example (a very likely scenario, with all of the recession talk beginning), you’re not throwing away a dime by refinancing to a lower rate.

-slow

Slow, I think you’re missing the point (pun intended). 🙂

If you’re going to use after tax figures, shouldn’t you do so with the point, which is also tax deductable?

To use your example of a 28% tax bracket, the $4000 point is effectively reduced to $2073.60. Divide the after tax difference of $46.02 and the break even point is 45 months.

Rhonda,

I’ve never read such a clear and succinct explanation of loan pricing. Thanks.

Rhonda,

You said:

“To use your example of a 28% tax bracket, the $4000 point is effectively reduced to $2073.60. Divide the after tax difference of $46.02 and the break even point is 45 months”

Huh.

Last time I checked, a 28% tax break on a $4,000 point would make the effective cost in a *purchase* equal $2,880, not $2,073.

And I should have clarified that the example I used was on a refi, not a purchase, so the points are amortized over the life of the loan (i.e., hardly amounting to much of a tax break per year).

So my question still looms. Are loan officers compensated for adding points to a deal?

-slow

How did I do that with the 4k? The figure should be $2800…you’re correct. So therefore, the break even point is still 5 years as in my original post.

The scenarios I have been discussing on this post have been purchases, not refi’s. And, in the original post, I suggest that paying a point may make more sense with a purchase than a refi. Again, there are factors, such as how long someone is planning on staying in the home, do they refi often, will they break even before the rate adjust (if it’s an ARM), etc.

Slow, sorry I missed your question. Some loan officer’s make “overages”, so the answer to your question is yes. That’s why consumers need to understand how loans are priced so they can see if a LO is charging beyond what is market price. Also, LOs are compensated with the loan is priced with zero origination/discount points, too.

I’m taking advantage of having decent temperatures and no rain today…off the the garden I go. 🙂

Thanks for the clarification. Much appreciated.

-slow

Thank you for your great comments!

Rhonda,

I do not agree with your quantitative methods to derive the payback period and neither would the business schools, CPAs, CFAs, economists, etc. Sadly, all too often lenders use that formula to answer a complex financial (finance the discipline not lending) question. The correct calculation is so complex that it cannot be done in your head, on scratch paper, or on a financial calculator. The model requires a spreadsheet with many discounted cash flow calculations.

The flawed calculation fails to account for the loan balance differential as the lower interest rate loan amortizes faster. Taxation must be accounted for on all cash flows.The tax treatment for points and interest differs in that points are deductible in the year of purchase and interest is deductible in the future period when paid. The flawed formula ignores the Time Value of Money from Discounted Cash Flow techniques. A dollar today is worth more than a year from now because of inflation, opportunity cost of investment alternatives and reinvestment rates.

The proper breakeven point calculation includes points, monthly payments, the interest on the points and monthly payments at the taxpayer’s savings rate, all reduced by the tax savings and decrease in the loan balance. The breakeven period is the intersection of the curves representing the total net costs of each loan. With your example data and a 0% reinvestment rate the payback period is 48 months.

Michael,

The purpose of the post was to give a simple formula for consumers to use to figure their break even. Would mind sharing your formula that you used to arrive at 48 months? Worse case, the formula I used is more conservative with a break even point at 5 years instead of 48 months.

I would rather have a buyer who is paying a point intend on living in the home for 5 years and breaking even earlier based on your formula.

Cheers to you, too! 🙂

Hello Rhonda,

I wish it were simple. There is so simple and accurate method to calculate the BE. Unfortunately, I can’t fit the caculations into this text box because it isn’t one formula or calculation. It is serious of about half a dozen discounted cash flow calculations in addition to a loan amoritzation table. I’ll chat with Dustin to find a way to post the Exel spreadsheet to the website for public download.

Rhonda,

Please comment on negative points and when they are retained by the broker (yield spread premium)?

Micheal,

I’m not a broker. I’m a correspondent lender, so we’re a little different breed of lender (like a combo of a bank and a broker).

What would you like me to specifically comment on, Michael? In my scenario above, I addressed how pricing a mortgage with a slightly higher rate can cover closing costs…I’m not totally sure what you’re after.

Back to your formula, my point was to have a simple tool for consumers to use with a calculator when meeting with their Mortgage Planner to weigh out the cost of the point.

(key word: simple). 😉 On comment 16, did you mean to say “so” simple or “no” simple?

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It has been my experience that a majority of consumers will take the lower payment/rate everytime. I always present 3 loan scenarios which include “no costs”, “no points” and “full costs” and customers take the “full cost” most of the time on purchases. I borrow the opposite way myself and try to explain to clients that having $4000 or more in reserves after closing is more impactful but they remain enamored by “lowest” payment/rate. I appreciate Michaels thoughts but his ideas far exceed the grasp of the average or even above average homebuyer.

The use of the described break even model works just fine for day to day lending work. I have experimented with the “after-tax” formula and even that starts their eyes glazing over. Helk, I have even gone so far as to show the “after-tax” breakeven coupled with the “borrow $4000 less” analysis and really put them to sleep. Keep it “simple” always works the best.

Thanks Rhonda for a “simple” idea and explanation although even simple can get complicated.

Warmly,

Bryant Keefe

Thanks, Bryant! It is all about providing options, educting clients and letting them decide.

Hello Rhonda,

I mistyped. I mean to say……….

There is NO simple and accurate method to calculate the BE. The simple calculation delivers a result that is 31% longer.

I found a better solution than trying to post the spreadsheet. I found an online version from a Wharton Business school Finance professor. The online tool can be found at http://www.decisionaide.com/mpcalculators/FRMBreakEvenCalculator/FRMBreakEven.asp.

Hello Rhonda,

Regarding the YSP, I was hoping you would comment on what is YSP and how YSP works. I have run into very few consumers that know about YSP and realize the YSP is frequently paid outside of closing.

Hi Micheal,

As I mentioned, I’m correspondent, we fund in our own credit line, like a bank and we broker very few loans. When I do have YSP, I add it to the pricing of the rate and give the benefit (the lower rate) to the borrower. It’s not paid outside of closing with my transactions.

You might want to ask a Mortgage Broker who is not a Correspondent Lender?

Rhonda

Jillayne,

That was great explanation. I agree some mortgage brokers do not explain YSP. Many can’t explain YSP because they don’t fully understand YSP or margins, indexes, etc for that matter. I have run into brokers trying to hide it!

BTW, I have attended your class a while ago. I was the only person wearing a suit. I was the geeky one in the back with the financial calculator asking all the numbers questions.

Hi Michael,

A Yield Spread Premium is the profit the mortgage broker made by selling the consumer a loan at a higher interest rate compared with the interest rate the consumer actually received.

Customer Joan: Happy with 8.75% interest rate.

Broker Jane: Sees that she can lock the loan in at 8.75% but rates are actually lower for Joan’s loan product. The banks/lenders will pay 2.25% to Jane to buy that loan at 8.75% because currently the rates are 6.50%. at par.

Broker Jane pockets 2.25% of the loan amount. On a 400K loan amount, that’s $9,000 that went into the mortgage broker’s pocket.

With that said, banks sell mortgage money all the time and make incredible yields. Banks are NOT required to disclose their YSP on the GFE or the HUD1 because their yield is a secondary market transaction. What happens after the close of escrow is not subject to RESPA. In a way, a mortgage broker could be considered more transparent than a bank.

UNFORTUNATELY most all mortgage brokers don’t properly explain or disclose their YSPs on the Good Faith Estimate. Then, when they show up on the HUD in escrow, the closer cannot comment. Unscrupulous mortgage brokers have many, many ways of explaining the YSP so as to help the consumer think that this is nothing.

Used properly, a YSP could be a way that a mortgage broker might offer a no-fee loan, then earn a yield and pay all the fees from his/her yield spread.

The mortgage lender I use never takes the yield. She always gives the customer the lower rate and stays with her 1% loan fee. Do not count on all mortgage lenders to be so inclined.

Brokers who complain about banks are whiners. We tell them: if you don’t like disclosing your yield, then go become a bank.

Mortgage brokers in this state are required to put their YSP on the good faith estimate. Percentage and dollar amount.

Many mortgage brokers don’t like to do this and instead quote a “range” of possible YSP at the bottom of the GFE. Our state considers this a deceptive practice. It is in the state DFI audit manual. A couple of months ago, I saw a GFE with a YSP range of “0 to 20,000.”

The customer pays the yield out of his or her own pocket every month, for the life of the loan, in the form of a higher interest rate.

I have a class called “How to avoid predatory lenders” for consumers. Send your homebuyers to this class. March 22, Northgate. Here’s the schedule:

http://www.bpiconsulting.net/upcoming.htm

Thanks, Jillayne. Since I’ve only worked for Mortgage Master, we don’t have the ysp issue on most transactions. When I do have ysp, it is disclosed on my gfe and, as I’ve mentioned, I add it to the price of the rate to essentially buy a lower rate for the borrower.

Hi Michael,

Oh sure, I remember you. Not. 🙂 Sorry but I get thousands of Realtors in my classes every year. I will remember someone’s name if they have a VERY interesting personality that comes out during the class. I’m visual. Let me go see a picture of you….Okay, I must have made a remark about the suit, right? I must have asked you if you were an attorney or a lender.

Glad to help with the explanation. I have a firm belief that all mortgage brokers fully understand YSP. Unscrupulous mortgage brokers know exactly how to explain it……in a way that is less than 100% honest and transparent. These folks are trained to memorize scripts with exactly what to say.

With that said, it is important to point out that there are many reputable. highly ethical mortgage brokers out there doing good work for consumers.

Brian Brady has done an excellent job tackling ysp, too.

http://delmar.typepad.com/brianbrady/2006/11/a_realtors_guid.html

Jillayne,

Regarding the transparency, I have run into a few (very small number) not so upstanding lenders on behalf of Reba’s residential clients. You should hear the stuttering on the other end of the phone when I ask about the secret compensation (YSP). Mr. Lender, of course I know about YSP. I crunch numbers for a living. I could talk about indexes, margins, and discounted cash flows all day. 🙂

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Great post Rhonda.

I am considering a FAQ for my website on this very issue.

I am a broker, so I will also differentiate how banks get paid on loans too.

I am not afraid to put the ‘secrets’ out there… as a matter of fact, a LOT of my clients are quite educated in YSP.

See ya

Thanks, Tom. Are you doing a blog or adding pages to your website?

Hey Rhonda

Both, I guess.

I have a wordpress blog. I am not particularly impressed with it… but at least it is up and running.

I have a resources page with articles for homebuyers…. just good unbiased educational stuff.

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I just linked back to this post from your June 1, rates post. This was such a good explanation of loan pricing, Rhonda.

Brian, thanks so much! I write for the consumer. I want borrowers to be able to understand the process and what they need to know in order to be able to help themselves in the mortgage process. I’m sure it’s no different than how you treat your mortgage practice.

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Hello,

I had a question regarding the tax treatment of negative points. I can’t seem to find much information on this subject, and have yet to find information on the tax treatment of negative points. Specifically, if negative points are in excess of all closing costs, how is the excess treated for tax purposes (is the excess taxed as additional income, etc.)

Any help would be greatly appreciated. Thank you.

Matt, I recommend seek advice from a CPA.

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I still get hits off of this trackback…..

Good stuff!!

Thanks, Tom! I use this post quite a bit with my clients when I review whether or not they should price their mortgage with points. 🙂

On another post at RCG, Michael Lindekugel asked a question that I feel is more appropriate to be answered on this post::

For starters, I’m typically not a huge fan of paying extra points (especially over 1 point) as odds are, many folks may refinance or buy another home and not receive the full benefit of paying those points. However, I will have clients who get their minds set on a specific rate and want to pay points. I feel that it’s part of my duty as a Mortgage Professional to review the costs factors and estimated break even times so that clients can make an informed decision.

I’ll address Michaels example, however, the rates are not accurate. 5% would be closer to 1 point (give or take) right now…I’ll follow up with a comparison about that. If you read the comments in this post or where I moved this comment from, you’ll see that Michael does not agree with my calculations. My intent on this blog (and my other blogs) is to provide consumers with quick and easy formula’s (I refer to as “street math”) that can be used to roughly estimate your break even period. There are so many other factors that come into play and various calculations you can use to fine tune figures down to your specific scenario–and then someone else may argue you’ve figured it out all wrong. I all consumers to have the ability to jot down figures with paper and pen at the LO’s office (or better yet, borrow the LO’s calculator if they don’t have one on them) to come up w/basic figures. Sorry for the long explanation–I want you (RCG readers) to understand where I’m coming from and what my intent is. 🙂 I’m merely trying to provide formula’s that anyone can wrap their brains around.

For this scenario, I’m assuming a loan amount of $400,000 (since this is the loan amount I use for rate quotes and probably 90% of all scenarios unless someone requests something else).

A rate of 5% provides a principal and interest payment of $2147.29 and at 2 points, costs $8000.

A rate of 5.75% has a P&I of $2,334.29 with 0 additional cost in loan origination/discount fees.

The difference between these two payments is $187.00. If you were to divide the cost of 8000 by the difference in payment, you could see that it will take approx. 43 months to break even on the cost.

BUT…WHAT IF…the borrower used that $8000 to reduce their principal instead of paying points…so instead of a loan amount of $400,000, we now have a loan amount of $392,000 with a rate of 5.75% at zero points. At 5.75%, the P&I is $2,287.61 with a difference of $140.32 per month. Comparing this to the paying points scenario, it will take approx. 57 months to break even on the cost. (Street math, Michael, street math). 😉

A more accurate comparison based on current rates would be 5% at 1 point. So the cost would be reduced to $4000 and the break even period would be 21 months for 1 point (4000/187) or, if the borrower reduced the principal by $4000 to $396,000 (instead of paying the point) they would have a principal and interest payment of $2,310.95 with a difference in payment of $163.66 with a rough break even period of 24.44 months.

There are factors on top of factors that can be applied here. What if the consumer opted to invest the points instead of buy the rate down…how about factoring their income tax information…what if…what if… there are many sites on the internet (some have been posted here all ready) available for consumers to plug in their data–and they should. Consumers (in general) need to giving their mortgages more consideration than years past.

The point is, it’s not for me to tell a consumer whether or not they should pay points. It is for me to review the possible scenarios with the consumer to show them the effective costs of points. I also review what the consumers long and short term plans are–what’s on the horizon for them. How long do they picture themselves living in this home or retaining the mortgage (are they likely to refinance)? Do they have young kids, will they be retiring soon…etc.

It’s all about starting a discussion to help the client make the right decision on how they want the mortgage priced because the choice is theirs.Rhonda, connecting up what I just wrote in the other thread, it appears I totally missed this other discussion. I’m somewhat relieved in that it means I’m not losing my memory. 😉

Kary, I think you caught me editing my comment. Since it was a lengthy response…I wanted to “save” as I wrote it. Happy New Year!

Rhonda wrote: “I also review what the consumers long and short term plans are–what’s on the horizon for them. How long do they picture themselves living in this home or retaining the mortgage (are they likely to refinance)?”

Yes, I had missed this.

It makes me realize that I’m not only a real estate agent’s worst nightmare, I’m also a mortgage broker’s worst nightmare.

In my 50 years I’ve only bought two places and refinanced twice (and one of those was out of a 10.25% loan). If everyone was like me, agents and mortgage brokers would starve to death. If everyone was like me, the entire economy would collapse because I tend to use things longer than most, and don’t buy a lot of crap.

Kary, I remember doing my last mortgage (before I was in lending) and my LO suggested that I consider an ARM with a lower rate because of how often I moved (that was my 5th home purchase). For some reason, I felt a little insulted and stuck with my 30 year fixed, ignoring his advice.

It would have made sense to opt for the ARM because in hindsight, I did refi again just a year later. I had a 90% LTV w/MI (can’t remember what the rate was) and the bank would not drop my MI due to not meeting the seasoning requirements even though home values were climbing then. So..I refi’d to a 5 year ARM (I was in mortgage w/this refi) at 3.625% because I was pretty sure I’d be selling the home by the 5 year period (and moving in w/my now husband)…oh…and I dropped the pmi.

It is important to know what someone’s habits are with their mortgage. My LO tried to provide me with good information but I wasn’t able to listen. If someone tends to refinance often or if they tend to buy homes and not keep them for a long period of time (I was “trading up” and not keeping as investments), they should try to obtain mortgages with zero points and/or zero closing costs. With that said, our current pricing that’s available doesn’t make zero points or zero closing costs attractive what-so-ever.

Rhonda,

With 5% @2 points and 5.75% @0 points your simple street math of 43 months is off by 10 months or 30%. The correct break even point is 33 months.

Do you believe a margin of error of 10 months or 30% is acceptable for your clients?

Michael, I’m not sure where your attitude towards me comes from but I sense a bit of hostility.

Would you mind sharing how you came to your results instead of just declaring me wrong?

I calculated the answer long hand with amortization tables adding up the total cost of the loans less the principal reduction until the break even point is met. The Decisionaide calculators will produce the same result.

Rhonda there is no hostility toward you. I think I asked a simple question. Do you believe a margin of error of 10 months or 30% is acceptable for your clients?

Michael, I should have been more clear–sorry. Can you clearly show in detail how you came to your figures so everyone can understand. I like to give actual examples so we can follow your example instead of just reading your answer.

If you’ve read my earlier comments, my “street” or “quick” math may not be perfect, but if someone is in need of ball park figure, it serves that purpose.

Setup two amortization tables. Compare the total costs month by month from each table until the higher cost loan is now the lower cost loan. The month of the change is the break even point. In this example the point is 33 months.

5% @ 2 point

Total cost $61,896 = $70,861 principal and interest + $8,000 points – $16,965 principal reduction.

5.75% @ 0 points

Total cost $62,139 = $77,032 principal and interest + $0 points – $14,893 principal reduction.

yes, I read your earlier comments.

Thanks, Michael! Happy New Year.

BTW I’m taking this week off and probably won’t be around much for commenting. See you all in 2009!

Re habits, a couple of years ago I came across a neighborhood, in Marysville I think, where everyone seemed to refinance at least once a year. It was very odd how widespread it was. I suspect just about anything in that neighborhood today is probably a short sale.

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