Low Points or Low Rates?

As if mortgages weren't confusing enough, mortgage companies offer you the opportunity to lower your rates by increasing the points you pay. If you're not careful, though, you might end up with a more expensive loan.

Interest Rates

Mortgage companies tack a recurring charge on money you've borrowed: that's the interest. Interest rates are the amount of that charge as a percentage of the amount borrowed. So, an interest rate of 5% means that you pay an average of 5% of the loan balance every year.

Points

Points are what mortgage companies charge you to make a loan. This pays them for their time, materials, costs, and leaves something left over for profit. One point is one percent of the loan value.

What do mortgage companies want? Points or interest?

So if the mortgage company gets to keep both the interest and the points, why are they trading them off? Why pay both points and interest? It's true that both the interest and points are money that the mortgage company is making from your loan. But most mortgage companies would rather have points than interest.

Suppose you have a 30-year loan and pay it off in 15 years. That's great for you. But the mortgage company loses 15 years of interest payments from you. That's not great for them. Suppose you win the lottery tomorrow and pay off your brand new home loan. The mortgage company now gets zero in interest. But they still get to keep all the points they charged you. You paid them these points or they became part of the loan balance (so you had to pay them when you paid off the loan).

APR

To get you to pay points rather than interest, mortgage companies will offer you high points and low interest loans that are actually cheaper in the long run than low points and higher interest loans.

That's where APR comes in. The APR combines the interest rate plus the points and other fees and then calculates this total amount into an annual rate. This is the actual cost of the loan. It doesn't matter what the points or the interest rate are — a lower APR means you pay less for the loan over the full term of the loan than a higher APR.

Typically, a low points loan will have a higher APR than a high points loan. Why? Mortgage companies would rather have the points, which are guaranteed money for them, than the interest, which isn't. But you have to check the APR to get the accurate cost of the loan.

Lowest APR May Not Be The Best

Seems like a slam-dunk, right? Pick the loan with the lowest APR and you'll be getting the cheapest loan and the lowest monthly payments, right?

Well, not really. Remember: the mortgage company gets to keep all the points it charges. It may not get all the interest it has coming to it because you might pay off the loan. How? By refinancing. Selling the house. Getting a better paycheck and paying down your mortgage faster. If you do any of these, a high points, low interest and low APR loan is the worst way to go: you lose more money than a low points, high interest and higher APR loan.

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So interest rates, points, and APR count for nothing all by themselves. It's you and your future that counts. If you know that you're going to be in a mortgage for the entire term of the mortgage, then you want the lowest APR and the lowest monthly payments. If you're planning on moving or refinancing soon, then you want the lowest points. If you imagine that you're going to be in the house and the mortgage for a while, but you will probably pay it off, refinance, or sell your house before the end of the mortgage term, you'll want something in between the lowest points and the lowest APR.