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The Relationship Between Interest and Points
When shopping for a loan, generally the lower the interest rate, the less money you pay over the long run. However, if the interest rate is really low- there may be points (an upfront fee you pay to a lender to lower your interest rate) that could significantly increase your closing fees. It’s a good idea to understand exactly what an interest rate is, what a point is, and how their relationship is a matter of tradeoffs.
- PRO: You pay more points; you get a lower interest rate.
- CON: Points will make your down payment higher.
- PRO: Points are tax deductible.
Interest Rate:
Interest, or the cost of borrowing money, varies depending on market conditions, the lender, the loan program, the down payment amount and the quality of your credit record. It may also depend on how much cash you have available to pay points, or prepaid interest, up front. Again, consider the tradeoffs, and shop for rates with more than raw numbers in mind. The best interest rate for you isn't always the lowest.
Points:
Points, also known as discount points, are fees that you pay to a lender. One point equals 1 percent of the loan amount (or $1,000 on a $100,000 loan). Many lenders offer "no-points" loans, but you pay a higher interest rate. Most lenders offer a number of rate/point combinations from which to choose. For example, a lender may offer a 7.75 percent loan for $100,000 with no points, for a monthly payment of $716.41. The lender may offer the same loan with a rate of 7.25 percent in exchange for two points, for a monthly payment of $682.18, or a rate of 6.75 percent in exchange for four points, for a monthly payment of $648.60. This example shows the longer you hold your loan, the more you benefit by paying points to get a lower rate, because it has more time to create savings. The less time you plan to hold the loan, the less you benefit from paying points.
Look beyond interest rates
If you only consider interest rates and your monthly payment, for example, you could pay thousands of dollars more than you should over the life of your loan. For example, consider long-term interest costs. On a 30-year, fixed-rate loan of $100,000 at 7 percent, you would pay $239,500 in total interest charges by the end of the loan term. You would pay $276,500 on the same loan at 8.5 percent. If you only qualify for an 8.5 percent loan, then it may make sense to buy down your interest rate by paying discount points up front, especially if you plan to hold your loan for a long time (which means you'll incur the greatest amount of interest charges).
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