Why Many Borrowers Select the Wrong Combination of Interest Rate and Points

July 4, 2011

Lenders generally offer borrowers alternative combinations of interest rate and points: low rates are offered when the borrower pays points to the lender, high rates are offered when the lender pays points to the borrower. Points paid by the borrower are an upfront cash outlay, whereas points paid by the lender are used to pay the borrower's settlement costs, including escrows. On a 30-year fixed-rate mortgage (FRM), a lender might offer 10 or more combinations.

Borrowers frequently don't choose the combination that is best for them for the same reasons they often don't select the best type of mortgage: their own ignorance, poor advice, and inadequate disclosures. Some borrowers don't understand that there is a choice to be made, and their loan provider (loan officer or mortgage broker, henceforth LP) may have no interest in taking the time to explore an issue that can be avoided.

One way to avoid it is to simply steer the borrower toward the rate that carries zero points -- or close to it. While steering borrowers toward a mortgage that carries a larger commission for the LP is now illegal, it is not illegal to steer a borrower toward the mortgage that involves the least time and effort for the LP.

Borrowers saddled with LPs who would prefer not to be bothered should take control of the decision themselves. The issues are not that complex, and are summarized in the table below.


Borrower Is Income Short

Borrower Is Cash Short

Borrower Expects to Have Mortgage 4 Years or Longer

1. Select High Fees, Low Rate

2. Select Rate at Zero Fees

Borrower Expects to Have Mortgage Less Than 4 Years

  3. Select Rate at Zero Fees

4. Select Negative Fees, High Rate

Borrowers with long time horizons, defined for convenience as more than 4 years, profit from paying points that reduce the rate because they will enjoy the benefit of the lower rate for a long period. The higher fees can be viewed as an investment that earns a high rate of return. The longer they hold the mortgage, the higher the return. I have two Points Calculators that calculate the rate of return in any given case.

If the borrower with a long time horizon is also income short, the case for paying points is clear-cut because the lower rate reduces the payment. This is box 1 in the table.

 Borrowers with short time horizons will profit by selecting a high-rate mortgage on which the lender pays some or all of the borrower's settlement costs. The profit arises from the short period over which the borrower pays the higher rate needed to reduce the upfront cash outlay.

If the borrower with a short time horizon is also cash short, the case for paying a higher rate is clear-cut. The borrower reduces the cash outlay and doesn't pay much to do it. This is box 4 in the table.

But some borrowers may be forced to compromise. If the borrower has a short time horizon and is income-short, as in box 3, he is in a conflict situation. Though he would profit from paying a higher rate, he can't afford it. A compromise is necessary, perhaps by selecting the rate closest to zero fees.

Similarly, the borrower with a long time horizon but cash-short, as in box 2, is in a conflict situation. Though she would profit from paying points, she can't afford it either. The compromise of selecting the rate closest to zero fees makes sense in this case as well.

The United States is unique in offering borrowers the rate/point option. To my knowledge, it is not offered anywhere else in the world. While the option provides little benefit to many borrowers who depend on others for guidance, borrowers do not need a PhD to find their own best path.

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