DROdio Real Estate

Discount points and origination fees can often be confusing to buyers. Here's how they work.

The first thing you should know is that we consider discount points to be "good" points that benefit the buyer, while origination fees are "bad" points that benefit the lender. The difference is that discount points will get you a lower loan rate, but origination fees will not. The origination fee is generally a somewhat to very negotiable fee (although the lender won't want you to know that) that the lender is charging you to do the loan. The lender is saying "based on your risk profile, we have to charge you an origination fee to cover our risk." That origination fee goes right into the lender's pocket and is used to adjust the risk profile of the buyer, so if you're a riskier borrower, that fee is likely to be higher. Often (although not always), the origination fee is used to pay the loan officer's commission on the deal.

Discount points are another matter entirely. These are fees you pay at closing to get a better interest rate. While it is possible the lender may force you to pay discount points to get a certain rate based on your risk profile, usually points are optional. One point is equal to one percent of the loan. So for example, if you're getting a loan for $800,000 and your base interest rate is 6.5%, one point will cost you $8,000. You might expect that one point would lead to a 1% discount on your interest rate, but that is not the case. (That would be too easy, right?!) The first point you pay might get you a 0.5% decrease in your rate. But it's a situation with diminishing returns - the more points you pay, the smaller your incremental lowering of your rate.Here's what you need to consider when you're buying points: How long will you be in the property? If you're not sure, you probably shouldn't buy points unless you know it'll be for a while.

Let's look at an example to learn why: Let's say your rate is 6.5% with zero points (scenario A), or 5.75% with 2 points (scenario B - the first point got you a 0.5% reduction and second point got you a 0.25% reduction in rate). You would have paid $16,000 for those 2 points at settlement.Your monthly payment on an $800,000 loan would be as follows:

Scenario A: $5,056.54

Scenario B: $4,668.58

Now, if you sold your home after 2 years, your principal balance would be:

Scenario A: $777,356
Scenario B: $774,080 (a difference of $3,276)

And if you sold your home after 5 years, your principal balance would be:

Scenario A: $743,833
Scenario B: $736,480 (a difference of $7,353)

And after 10 years it would be:

Scenario A: $671,219
Scenario B: $$657,478 ($13,741)

(Want to run these calculations yourself? You can use a loan amortization table like this one)

So as you can see, even living in the property for 10 years, you still don't recoup your initial $16,000 investment. Now, that statement isn't entirely accurate, because on the one hand, you would have paid less in total, aggregate interest payments with the lower rate, but on the other hand, you're also not counting what $16,000 could grow to if you invested it in a solid investment, so there are other factors at play, but the general idea is that you shouldn't pay discount points up front unless you know you'll be in the property over the long term, because you lose that money when you move after having owned the property for a short amount of time.

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This entry was posted on Monday, August 18th, 2008 at 9:57 pm and was filed under All About Home Financing & Loans, The Buying Process, drodio.com. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.