Why “Breaking Even” Should Be Important to Mortgage Borrowers

Is it financially prudent to pay points (discount and/or origination) to obtain a lower mortgage rate? To find that out, we need to do a ‘break even’ calculation. There are two important questions to ask before we begin the break even calculation:

1. Time Horizon – How long do you plan on living in your home?

2. Risk Tolerance – With regards to your finances, how much risk are you willing to take to gain a potential reward?

To better illustrate this point, let’s look at a hypothetical borrower and mortgage professional discussing points, loan programs, and mortgage rates.

MP (The Mortgage Professional): How long do you plan to live in your home?

Borrower A: I’d say more than 5 years, but less than 10 years

MP: What is you risk tolerance level?  Meaning, are you a person that is willing to take some financial risk with a potential for financial reward, or do you prefer to play it safe?

Borrower A: I like to play it safe

MP: Then, let’s talk about a 30 year fixed mortgage. That seems to fit your situation the best I think.

Borrower A: Great. My next door neighbor’s brother said at our BBQ yesterday that he got 6.000% on a 30 year mortgage.  That’s what I want … 6.000%.

MP: Okay.  Today’s 6.000% 30 year fixed conforming rate would cost 2 points for a 30 day lock price.

Borrower A: Wow, 2 points.  How much is that going to cost me?

MP: Based upon your mortgage amount, multiply 2%, the cost for 2 points is $6000.

Borrower A: Um, okay.  That’s sounds like a lot of money.  What would you recommend?

MP: Let’s do a break even calculation and compare payments/rate for 2 points, to a zero point rate

Borrower A: What is a break even calculation?

MP: A breakeven calculation will show us if it make sense to pay points or not based upon how long it takes for the investment of paying points to get a lower rate and how that compares to the mortgage payment and your time horizon for living in this home. For example:

2 points/$6000 … 6.000% / $300,000 mortgage … $1,798.65/mo P&I

Zero points/$-0- … 6.375% / $300,000 mortgage … $1,871.61/mo P&I

The payment difference between a 2 point loan and a zero point loan is $72.96/mo.  Take $6000 (2 points/6.000%) and divide it by $72.96 (difference between 2 point/6.000% and zero point/6.375%) and you get 41.12.  So, your breakeven is 41.12 months, or 3 years/5 months.  It would take you 3 year/5 months to recover the $6000 investment (2 points) you paid in comparison to getting a zero point rate at 6.375%.  So, based upon your time horizon and your risk tolerance level paying 2 points may not be too bad.  The key is you would need to live in this home for at least 5 years or more to have this 2 point rate make sense.  The longer you live in this home at the 6.00% rate the better your savings to investment will be.

Borrower A: So, if I pay $6000 in points for 6.000% and compare it to paying zero $$ and getting 6.375%, I save $72.96/mo and it would take me a little over 3 years to recover the $6000 in the monthly savings?  What if we move in less than 3 years and I sell the home?

MP: Then, you would not fully recover the points paid for the 6.000% rate.

Borrower A: But, what if mortgage rates go down below 6.000% in the next few years?  Will it make sense for me to refinance then?

MP: Maybe.  If in the future you contact me my first two questions would be ‘What is your time horizon on living in your home?  And, has your risk tolerance changed from our last mortgage together? Then, I would do a break even calculation again.  Maybe mortgage rates would justify a refinance, but maybe not.

So, you see mortgage borrowers … it’s more than rates & points.  It’s about breaking even on what you pay in points in relation to the mortgage payment you will pay. Be sure you know when you break even.

 

 

September 8, 2008