Friday, April 2, 2010

Potential homebuyers and homeowners interested in refinancing watch mortgage interest rates closely to make sure they lock in the best rate possible. Mortgage rates are historically low, hovering around 5 percent, which has increased the number of mortgage applications in recent months.

Speculation is rampant about whether mortgage rates will rise in 2010, with varied opinions on when or if this might happen.

“Mortgage rates always fluctuate,” says Gail Kullman, a certified mortgage planning specialist with PrimeLending in Alexandria, Va. “But with rates as low as they are now, there is more of an opportunity for them to rise than to fall. That said, they may not rise at all this year, given the state of our economy. Mortgage rates are more likely to go up as the economy becomes more robust.”

Mortgage consultant Paul Defngin, with the Parsons Mortgage Group at Nationwide Home Mortgage in Rockville, Md., says there is an odd phenomenon now in which some of his customers think a mortgage rate of 5 percent is too high.

“A year or two ago, rates were 6 percent, and that was considered good,” Mr. Defngin says. “People are just not realizing how great mortgage rates really are right now.”

When comparing mortgage loans, borrowers need to be careful to check on whether the rate depends on paying discount points. A discount point, equal to 1 percent of the loan amount, is simply a way to prepay the interest on the mortgage to bring down the rate.

Lenders do not necessarily see a correlation between the level of mortgage rates and the use of discount points. Higher mortgage rates do not necessarily cause an increase in the number of customers opting to pay points. Even when mortgage rates are low, some borrowers opt to pay points.

In addition to discount points, which are optional for every consumer, lenders charge an origination fee, usually 1 percent of the loan. Often, these origination fees are also called points.

“It used to be prevalent that all lenders would quote loans with a 1 percent origination fee plus discount points of 1 [percent] or 2 percent,” says Glen Lazovick, senior vice president of business development and marketing with Mid-Atlantic Federal Credit Union in Germantown, Md. “Over the years, this has changed, and zero-point loans have become more common. The origination fee still has to be paid, though, so a ‘zero point’ loan will just have wrapped the origination fee into above-par pricing.”

Consumers need to ask each lender to state clearly whether there is a loan origination fee and whether the loan quote includes discount points. Each borrower needs to know upfront the total points to be paid at the loan closing.

Deciding whether to pay discount points depends on the individual circumstances of the borrower and his overall goal.

James Tompkins, a senior loan officer with Coldwell Banker Home Loans in North Potomac, Md., says, “Paying discount points to buy down the interest rate may make sense for first-time buyers because they will want to keep their monthly payments as low as possible. It also could make sense for someone on the cusp of meeting the debt-to-income ratio. If they have the cash to lower their interest rate a little, then they might be able to qualify for the loan because their monthly payments will be lower.”

Mr. Defngin says that while the amount of the interest rate reduction per discount point varies, it is typically about a quarter percent.

“Sometimes paying a point will only save you $20 or so in interest payments each month, so it doesn’t always make sense to pay points,” he says.

Mr. Lazovick says the first factor in deciding whether to pay points should be an estimate of how long the borrowers intend to stay in the home.

“This is even more important if someone is refinancing, because they may want to refinance again before they have recouped the cash they spent on the points,” Mr. Lazovick says. “If someone thinks they will sell their home in two years or so, they may not get their money back. The longer someone intends to stay in the home, the more it makes sense to pay points.”

Determining whether to pay discount points depends on a math calculation.

As an example, on a $300,000, 30-year fixed-rate loan, the monthly principal and interest payment at 5 percent would be $1,610.46. If the borrowers paid one point at $3,000, they could potentially pay 4.75 percent interest for a monthly principal and interest payment of $1,564.94. The difference in payments would be $45.52 each month. At that savings level, it would take about 66 months - 5 1/2 years - to recoup the $3,000.

“If someone is only staying in the home six years, then it wouldn’t make any sense to pay that point,” Mr. Lazovick says. “If they intend to live there for 30 years, it might. But the borrowers should also really look at whether there are enough savings there to make it worth it. Everyone should think about the difference between the monthly savings and their ability to have cash reserves. In the above example, I think it would be much better to keep the $3,000 in the bank and invest it or save it for emergencies rather than save $45 per month on the mortgage payment.”

Mr. Tompkins points out that the savings from paying points on larger loans will make a bigger difference in the monthly payment. But even then, he says, the borrowers need to make a calculation based on how long they will stay in the home.

“Most people today keep their loan for only three to five years before they refinance or move,” Mr. Tompkins says. “If it will take you 60 months or more to recoup the money you paid for discount points, it probably isn’t worth it.”

Another important factor in the discount-point decision is that points paid at settlement for a home purchase are tax-deductible. Consult a tax adviser for advice on this topic, but lenders say points paid when refinancing also are tax-deductible but must be amortized over the length of the loan.

“Typically, borrowers who are refinancing do not bother to pay points, partly because of the tax issue and also because they don’t always want to come up with additional cash at the settlement,” Mr. Defngin says.

Ms. Kullman says discount points may make more of a difference when borrowers choose an adjustable-rate mortgage (ARM).

“One discount point on an ARM can bring down the rate by one-half percent, although this varies along with interest rates,” Ms. Kullman says. “ARMs have something of a bad reputation right now, but they can be a great loan for some individuals. For example, if someone knows they will be moving in three years for a military assignment or relocation, they can choose a five-year ARM and save money on their interest rate. If they can drop that rate by another half percent by paying one point, it might be worth it. Everyone just needs to make the calculation and make sure they are not overpaying discount points without enough savings benefits.”

Another option for buyers to consider is asking the seller to pay one or more discount points at the closing.

“In a buyer’s market, it is not unusual at all for sellers to offer to pay closing costs for the buyers as an incentive,” Ms. Kullman says. “When this was a seller’s market, we really didn’t do many loans at all with points. Not only were sellers not offering to pay them, but buyers needed every bit of their cash so they could pay their own closing costs. Now we frequently see sellers paying points for their buyers.”

Mr. Lazovick suggests that buyers negotiate with sellers to pay the buyers’ points at settlement because the buyers will benefit throughout the life of the loan by paying a lower interest rate without incurring any costs. He also says that when employees are relocated, employers often pay points for the homebuyers at the closing as part of their relocation package.

“Most of the time, first-time buyers do not pay points themselves at the closing because they have less cash than repeat buyers, who can rely on the equity in their previous home for a down payment and closing costs,” Mr. Lazovick says. “Unless someone else is paying the points, such as an employer or a seller, we are not seeing a lot of borrowers paying points right now. The main reason for this is simply cash. If the savings are not high enough, people prefer to keep their money in the bank.”

Another option for borrowers besides paying discount points to prepay interest and earn an interest rate reduction is a buy-down. The most common type of buy-down, a 2-1 buy-down, means the borrowers pay extra cash at closing to buy down the interest rate for the first two years of the loan. Ms. Kullman says this can be expensive, costing approximately 2.75 points at closing.

“Borrowers must qualify at the higher rate of the entire loan so that the lender is certain they can afford the loan payments,” Ms. Kullman says. “A buy-down can be helpful to someone concerned about the sticker shock of moving from a rental to homeownership. It also can be a good plan for someone who is expecting a big salary increase, such as a buyer about to finish law school or someone promised a promotion in a year or so.”

For example, instead of choosing a 30-year fixed-rate loan at 5 percent with zero points, a borrower could pay 2.75 points upfront and buy down the interest rate to 3 percent for the first year. During the second year, the interest rate would be 4 percent. In years three through 30, the rate would return to 5 percent.

All potential mortgage borrowers should discuss the pros and cons of paying discount points with their lenders and calculate the potential costs and savings for their individual circumstances.

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