When you borrow money, you have to pay interest on your loan. The interest that you pay is expressed as a percentage of your loan amount.
When you buy a home, you pay a mortgage rate. This represents the interest you pay on your home loan. However, if you want to lower your mortgage rate, you can pay what are known as “mortgage points” in order to pay less.
Mortgage Rates
The mortgage rate is the interest that you pay in order to borrow money. It is expressed as a percentage of your loan amount, and as an annual rate. This is a simple example that offers a look at how interest works:
If you are borrowing $200,000, and your interest rate is 5.0%, it means that you pay $10,000 a year in interest. However, as your loan balance decreases, so does your interest fee. The next year, your loan balance might be $150,000 ― a 5.0% interest rate on that amount would be $7,500.
When a mortgage lender gives you money so that you can make a purchase, they are providing you with money that they can no longer use. You have to pay it back, but there is a chance that you won’t pay it back. Mortgage interest helps make up for this. When you pay interest on your home loan, the bank gets a return on the money paid out, and the money also helps protect the lender from as big a loss if you default.
When figuring the mortgage rate, lenders look at the average national mortgage rate. This rate is influenced by changes in the financial markets. Lenders then look at your credit history to determine whether you will get the best rate. If you do not have good credit, your mortgage rate is likely to be higher, costing you more over the long term.
Mortgage Points
Mortgage points, on the other hand, are used to lower the mortgage rate. While mortgage rates are expressed as annual percentages and recurring fees, mortgage points are paid only once, up front. A mortgage point is expressed as a dollar amount. However, that dollar amount is equal to 1% of the loan amount.
For a $200,000 loan, one mortgage point would cost $2,000.
Each mortgage point lowers the interest rate by ⅛ or ¼ of one point.
If you wanted to lower your 5.0% interest rate by ½ of a mortgage point (to 4.5%) on that same $200,000 loan, and your bank lowered the rate by ¼ for each point, it would take $4,000 (paid up-front) to get a 4.5% mortgage rate.
Over time, though, that $4,000 paid up-front could help you save of tens of thousands of dollars in interest charges.
It is important to consider your options before paying points. If you aren’t in the house for very long, the mortgage points you purchase will cost you more than the savings you get from a lower mortgage interest rate.