An interest rate is the price of money, and a mortgage interest rate is the price of money loaned against the security of a specific property. The interest rate is used to calculate the interest payment the borrower owes the lender.
The rates you see quoted are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment.
Take a 6% rate, for example, and assume a $100,000 loan. In decimals, 6% is .06, and when divided by 12 it is .005. Multiple .005 times $100,000 and you get $500 as the monthly interest payment.
Suppose the borrower pays $600 this month. Then $500 of it covers the interest and $100 is used to reduce the balance. One month later, when another payment is due, the balance is $99,900, and the interest is $499.50. The interest rate stays the same, but the interest payment is lower because the balance is lower.
Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, 3 points means a cash payment of $3,000. Points are part of the cost of credit to the borrower, and part of the investment return to the lender.
To my knowledge, points are only used in the United States. Borrowers need not pay points if they don't want to. While the quotations in the media usually include points, virtually all lenders are willing to make no-point loans if you ask for them. But of course the rate will be higher. The rate/point quotes you see in the media are what the lenders view as their "base" terms. But they have other rate/point combinations "in the drawer" to be trotted out when needed.
For example, a lender quoting 6.25% plus 2 points might also be offering 5.75% plus 4 points, 6.5% plus 0 points, and 7% plus a 1.5 point rebate or negative points.
Having these options is a positive feature of the U.S. system. The down side is that points add one more complexity to a process that is already compli cated enough. The reason lenders usually keep all the combinations but one or two in the drawer is that they fear overwhelming the borrower—and perhaps losing the loan to another lender who makes it simpler.
Some borrowers have little or no leeway because they are "cash-short" or "income-short". If they are cash-short they are obliged to avoid points in order to have enough cash to complete the deal. If they are income-short, they must accept the lowest rate available so that the mortgage payment won't be viewed as excessive relative to their income.
If you have sufficient income and cash, you should be guided largely by your time horizon. If you expect to have the mortgage a long time, paying points to reduce the rate makes economic sense because you are going to enjoy the lower rate for a long time. If your time horizon is short, avoid points and pay the higher rate because you won't be paying it for long.
How long is "long"? This is shown for you in calculator 11a at www.decisionaide.com/mpcalculators/ FRM BreakEvenCalculator/FRMBreakEven.asp and a companion calculator 11b applicable to adjustable-rate mortgages. Note that you may have a short horizon because you expect to move soon, or because you expect that interest rates will soon drop and you will be refinancing. I don't advise basing your estimated time horizon on interest rate expectations because you can't forecast interest rates.
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