Step 5: Understanding Mortgage Points and Interest Rates

Interest rates and mortgage points may not be the most exciting topics but understanding these terms and how to use them to your advantage could help you save money. First, what is an interest rate, and how can you get the lowest possible rate for your loan?

What’s an Interest Rate?

The interest rate is the amount the bank or lender charges you to finance your home, and it is paid monthly along with your principal (your loan amount). You will pay back more than you borrow, and the interest rate the bank charges will depend on several factors, including the current annual percentage rate (APR), the economy, and your credit score. Interest rates fluctuate daily, so some borrowers may choose to lock in their interest rate when applying for a home loan.

Should You Lock in an Interest Rate?

First, what does locking your interest rate mean? Simply put, the lender will freeze the interest rate so you are guaranteed that rate when you close – even if your closing is still months away. Since interest rates fluctuate, locking in the rate means you won’t have to worry about interest rates rising before you close. Conversely, if you lock in your rate and interest rates drop, you still must pay your locked-in rate. It’s a gamble since much depends on factors outside your control. Things like inflation, the stock market, even world events can influence interest rates.

One of the benefits of shopping around and getting several loan offers is to find the best possible interest rate. If you’re happy with the rate, it might be a good idea to lock it in. If you decide to take the gamble and you don’t lock in your rate, make sure you’re comfortable paying more if interest rates do rise.

If you locked in your rate but they dropped significantly, you could back out of that loan and reapply, but keep in mind you’ll lose time and money. You won’t get any of the fees you paid when applying for the loan, and you’ll likely have to pay all those fees again with the new loan application.

Understanding Interest Rate Tables

For many home buyers, the mortgage interest rate table is a confusing mix of numbers, but it’s easy to understand once you know how to read it. The typical interest rate table is comprised of one column featuring interest rates, and two other columns. One of these is for 15-year terms and the other is for 30-year terms. Each of these feature two columns of their own: monthly payment factor and total amount.

To determine how the interest rate impacts the amount that is paid on a loan, find the interest rate and the monthly payment factor on its same line for the type of mortgage you’re interested in. Take the monthly payment factor and multiply it by 100. Take that figure and multiply it by 12. Then take that number and multiply it by either 15 or 30 depending on the term of the loan. The answer is what you can expect your payment to be with that interest rate.

What Are Mortgage Points?

Points are fees that a buyer can pay directly to the lender at the closing in exchange for a lower interest rate on the loan. This is a popular way for a home buyer to reduce their monthly mortgage payment. One point costs one percent of the loan amount and the money essentially goes toward prepaying some of the interest on the loan.

While points are usually paid by the buyer, there are some situations where the buyer may negotiate to have the seller pay points. This money is often used to cover some or all the closing costs.

When Does It Make Sense to Pay Points?

If you’re taking out a long-term mortgage, paying points may be beneficial. By paying points, you can reduce your loan payments and save money over the life of the loan. Here are two examples:

  1. A home buyer takes out a $200,000 mortgage. If the buyer pays one point ($2,000), they will get an interest rate that’s lower by 0.25 percent and a monthly payment that’s about $30 less per month. Over the life of the loan, the buyer will save $10,616 versus paying no points.
  2. Using the same mortgage, if the buyer pays two points ($4,000), they’ll have an interest rate that’s 0.5 percent lower and a monthly payment that’s nearly $59 less. Over the life of the loan, the savings will be more than $21,000.

Another situation where paying points can be beneficial is when the buyer can comfortably afford the mortgage payment as-is. In this case, the buyer can negotiate the seller to pay points so their closing costs can be reduced.

If paying points will be a financial burden at a time when you’re already paying for so much, it may not be feasible to pay points in addition to closing costs and your down payment. If you don’t intend to stay in the home for more than a couple of years, you might not get a lot of benefit from paying points. You’ll need to stay in the home until you can recoup the prepaid interest. If you sell or refinance your home before you reach that point, you could end up losing money.