What does it mean to pay points?

When you go to get home financing, your lender will quote you an interest rate and it will usually cost you around 1 point, or 1% origination (both mean the same thing) to get that interest rate.  You can opt to not pay any points if you would like but your interest rate would be higher.  1 point is equal to 1% of your loan amount, so if your loan amount is $300,000 you will have to pay $3,000 for that interest rate.  Generally speaking, it usually makes more financial sense to pay the point if you’re planning to keep the loan for more than three to five years.  If you think that you’re going to refinance or sell your home in a couple years then it usually doesn’t make sense to pay the point.

Here is the best thing to do, have your lender quote you a rate with paying the point and then the rate with not paying the point.  Then take your origination cost and divide it by the difference in your monthly payments.  That number is the number of months it will take you to make up for the cost of the origination.  Which mean every month after that you will be saving because you paid the point.  Here’s an example:

$300,000 loan

Origination (or 1 point) will cost $3,000

The interest rate with paying the point will be 6.125%, so your payment will be $1822.83

The interest rate with not paying the point will be 6.5%, your payment will be $1896.20

The difference is $73.37/month.

So take $3,000 and divide it by $73.37 and you get about 41 months.  So after 3 and a half years (41 months) you will make up the cost of the origination which means ever month after that you will be saving $73.37 because you paid the point up front.

Also something to remember, your origination cost is tax deductible…make sure you talk to your CPA about it for the details though!

Debt-to-Income Ratio

Your debt to income ratio is a very important factor in determining how much of a monthly mortgage payment you can afford.  The bank likes to see your debt-to-income ratio at about 45% or less.  Some programs allow you to go as high as 55% and some only allow you to go up to 39%.  But 45% is a safe estimate since most programs accept that. 

So, if you need your DTI to be about 45%, how much does that mean your monthly payment needs to be?  Take your gross monthly income and subtract your liability payments.  Your liabilities are things like, car loan payments, student loan payments, minimum credit card payments, personal loan payments.  Think of it as loans that you are paying back.  So things like utilities, gym memberships, cell phone service are things that you are utilizing and paying as you go, so those you don’t count.  After you subtract your liabilities, multiply it by 45% and that is how much of a monthly mortgage payment (included taxes & insurance) that you can afford.

Example:

You and your spouse bring in together 6,000 a month.  Your liabilities are:

$250 car payment

$30 minimum credit card payment

$150 student loan payment

So subtract your liabilities from your gross monthly income and you get $5,570.  Then multiply $5,570 by 45% and you get $2506.50.  And that is how much of a mortgage payment you can afford. 

Remember that payment of $2506.50 includes property taxes and homeowners insurance.  Those payments can vary but for general purposes, multiply your desired sales price by 1.25% and divide by twelve for your monthly taxes and multiply your sales price by .2% to get your monthly insurance.  Example:

$300,000 house

300,000 x 1.25% / 12 = $312.50

300,000 x .2% / 12 = $50

So your taxes & insurance monthly payment would be $362.50.  Subtract that from 2,506.50 and you get $2,144.  That means your mortgage payment should be around $2,144. 

Wow, I don’t know if anyone really cares about that, but there you go…