Loan Points Mortgage Lending Practices
Mortgage loan points which is a term in real estate finance that causes much confusion. In finance, the word point means one percent of the loan amount. Thus, on a $60,000 loan, one point is $600. On a $40,000 loan, three points is $1,200. On a $100,000 loan, eight points is $8,000.
The use of points in real estate mortgage finance can be split into two categories: (1) loan origination fees expressed in terms of points and (2) the use of points to change the effective yield of a mortgage loan to a lender. Let us look at these two uses in more detail.
When a borrower asks for a mortgage loan, the lender incurs a number of expenses, including such things as the time its loan officer spends interviewing the borrower, office overhead, the purchase and review of credit reports on the borrower, an on-site appraisal of the property to be pledged, title searches and review, legal and recording fees, and so on. For these, some lenders make an itemized billing, charging so many dollars for the appraisal, credit report, title search, and so on. The total becomes the loan origination fee, which the borrower pays to get his loan. Other lenders do not make an itemized bill, but instead simply state the origination fee in terms of a percentage of the mortgage loan amount, for example, one point. Thus, a lender quoting a loan origination fee of one point is saying that, for a $65,000 loan, its fee to originate the loan will be $650.
Points charged to raise the lender's monetary return on a mortgage loan are known as discount points. A simplified example will illustrate their use and effect. If you are a lender and agree to make a term loan of $100 to a borrower for 1 year at 10% interest, you would normally expect to give the borrower $100 now (disregard loan origination fees for a moment), and 1 year later the borrower would give you $110. In percentage terms, the effective yield on your loan is 10% per annum (year) because you received $10 for your 1-year, $100 loan. Now suppose that, instead of handing the borrower $100, you handed him $99 but still required him to repay $100 plus $10 in interest at the end of the year. This is a charge of one point ($1 in this case), and the borrower paid it out of his loan funds. The effect of this financial maneuver is to raise the effective yield (yield to maturity) to you without raising the interest rate itself. Therefore, if you loan out $99 and receive $110 at the end of the year, you effectively have a return of $11 for a $99 loan. This gives you an effective yield of $11 divided by $99 or 11.1%, rather than 10%.
Calculating the effective yield on a discounted 20 or 30 year mortgage loan is more difficult because the amount owed drops over the life of the loan, and because the majority are paid in full ahead of schedule due to refinancing. However, a useful rule of thumb states that on the typical home loan each point of discount raises the effective yield by 1/8 of 1%. Thus, four discount points would raise the effective yield by approximately 1/2 of 1% and eight points would raise it by 1%. Discount points are most often charged during periods of tight money, that is, when mortgage money is in short supply. During periods of loose money, when lenders have adequate funds to lend and are actively seeking borrowers, discount points disappear.
The use of discount points is an important part of FHA and VA loans, because the FHA and VA set interest-rate ceilings on loans they insure or guarantee. With only two exceptions since 1950, the FHA and VA ceilings have been below the prevailing rates on conventional loans (non-FHA or non-VA loans). Thus, if the prevailing open-market interest rate on conventional loans is 10-1/2% and the FHA and VA ceilings are at 10%, a borrower will not be able to obtain an FHA or VA loan without offering the lender enough discount points to raise the effective yield to 10-1/2%. If conventional loans can be made at 10-1/2% interest, it is illogical for the lender to accept 10%. To obtain a 10% loan, the borrower must pay the lender four discount points.
However, the VA limits the number of points that the borrower is allowed to pay to 1 point for existing homes and 2 1/2 points for homes under construction, and these are usually consumed by loan origination costs. These are called borrower's points or service points.
Any additional points charged by the lender must be paid by someone other than the buyer. That usually means the seller. For example, on a $60,000 loan, when the market rate is 1/2% above the VA ceiling, this amounts to $2,400 in seller's points. In other words, out of the proceeds from the sale, the seller would have to pay the lender $2,400 so the buyer could enjoy the privilege of obtaining a loan with an interest rate 1/2% below the market.
By placing yourself in the seller's position, you can see the situation this creates. A buyer making an offer under the above conditions is in effect asking you to take a $2,400 cut in price. If you were planning on reducing your price $2,400 anyway, you would accept the offer. However, if you felt you could readily sell at your price to a buyer not requiring seller's points, you would refuse the offer. The alternative is to price the property high enough to allow for anticipated points. However, this is an effective solution only if your price does not exceed the VA certificate of reasonable value. If it does, the VA buyer is either prohibited from buying or must make a larger cash down payment. One reason for the success of private mortgage insurers is that they impose no restrictions on either interest rates or discount points.
Mortgage Loan Points To Home Loan Mortgage Types