Friday, May 08, 2009

Mortgage discount points: making cents of banks

Jack takes out a 100k mortgage at 5%. The bank offers to lower the interest rate by 0.25% if Jack pays $1,000 upfront, non-refundable, and not applied to the principle.

0.25% of 100k is $250, so Jack would effectively be earning about $250 per year, near the beginning, on his $1000 investment. Adjusting for inflation, and the decreasing size of the principle, and the returns Jack could have earned if he put the money elsewhere, Jack breaks even within about 6 years, and comes out way ahead by the end of the 30-year mortgage.

Why would the bank give up so much in future interest payments in return for just $1,000 today?
  • Since the $1,000 that Jack pays is non-refundable and is not applied to the principle, the bank gets to pocket that money even if Jack sells the house or refinances the day after he takes out the mortgage. By accepting money upfront in return for lower interest payments, the bank is betting that Jack will sell or refinance within about 5 or 6 years, before the lost interest revenue adds up to $1,000.
  • Banks are interested in attracting customers who will pay back the entire loan. If Jack has an extra $1,000 to offer upfront, and he understands how this will help him in the long run, then Jack evidently is interested in the long run and is capable of planning for the long run. This is exactly the kind of mortgage customer the bank is looking for, and so the bank is willing to extend a lower interest rate to Jack so that he won't go to a different bank for loan.

1 Comments:

Anonymous happypappy said...

Good business sense: separating the sheep from the goats.

5:10 AM  

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