Even after careful shopping, many people have a hard time comparing loan terms and deciding whether to pay more points for a lower interest rate.
Interest rates are the most obvious difference between loans -- and an important one, because a small difference in rate can add up to big dollars over the 30 or so years you'll be paying off your mortgage.
For example, if you took out a $200,000 fixed rate loan at 5.25%, you'd have monthly payments of about $1,104 and pay a total of $197,587 in interest -- on top of the underlying principal amount -- by the time you've paid off the loan. If, instead, interest rates were at 5.75% when you took out the loan, your monthly payments would be approximately $1,162, and you'd pay a total of $220,172 in interest by the end -- more than the amount of the original loan!
In addition to comparing interest rates, look at the many types of fees -- and fee amounts -- associated with each mortgage you're considering, including loan application fees, credit check fees, and points.
Points often comprise the largest part of what you pay the lender up front, so it's important to understand how they work. They're considered prepaid interest in order to lower your overall interest rate.
One point is 1% of the loan principal. Thus, if you're borrowing $250,000 at two points, you'll pay $5,000. There's normally a direct relationship between the number of points lenders charge and the interest rates they quote for the same type of mortgage, such as a fixed rate. The more points you pay, the lower your rate of interest and vice versa. However, by crunching the numbers, you may find a slightly better deal at some interest rate/point combinations.
Comparing Points to Interest Rates
Before comparing points to interest, factor in how long you plan to own your house. The longer you live there (or pay on the mortgage), the better off you'll be paying more points up front in return for a lower interest rate. On the other hand, if you think there's a decent chance you'll sell or refinance within two or three years, we recommend that you get a loan with as few points as possible.
You'll find a helpful chart showing when it makes sense to pay additional points for a lower interest rate, based on how many years you plan to stay in your home, in Nolo's Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo).
Annual Percentage Rates
One method to compare loans with different points is to use the annual percentage rate (APR), which lenders must disclose to borrowers under federal law. The idea is that the APR calculates the cost of a loan as a yearly rate. The resulting figure can be misleading, however, as it assumes that the loan will not be paid off until the loan term ends. While most loans are for 30 years, people generally pay off their loans before the loan term ends (because they move or refinance). Also, different lenders have various ways of calculating costs included in the APR, so that a loan for the same dollar amount and number of points may have different APRs with different lenders.
To compare up to three loans with different combinations of interest rates, points, and closing fees, use Nolo's free mortgage comparison calculator. It allows you to enter the loan terms (rates, points, fees), as well as your estimate on how long you will stay in the house, and compare the performance of the various loans: total payments made over the course of the loan, taxes saved, and APRs.