What’s a Basis Point and How Will It Impact My Mortgage?

Gentle Readers,

You’ll recall that I want to buy a small place of my own, but that I have a lot of learning to do in the meantime. I understand how mortgages work in general, but a term I didn’t fully understand is Basis Point.

Mortgages are simple.

They are loans that are supported by collateral, ie the building you live in. You don’t make the proper payments, and your home can be returned to the mortgage lender. Your right to “your” home is conditional while there is a mortgage outstanding. Not a good look for you since you would prefer to remain living in the home. The lender makes money off of the loan itself through origination fees and interest payments. The lower the mortgage rate, the lower the cost of the loan for you. There are other parts of the mortgage, ie taxes and insurance, but I’m not going to write about those today.

There are a range of available down payments that are based on percentages of the total house and land value. It used to be standard for a buyer to pay in cash 20% of the value of the home. That standard is less likely these days. Some down payments are 3.5% of the home’s value or lower. I hope to do a 10% down payment for a home that is less than $170,000. My down payment would be $17,000 plus or minus some fees and my mortgage would be for $153,000. When I look at Bankrate’s Mortgage Calculator for those terms with today’s interest rates (3.39%), I would expect to pay $677.68 monthly for 360 months. Roughly equivalent to my current rent, which is why it is the top end of what I’d like to pay. I would actually prefer to pay much less.

Most lenders and buyers will agree to a 15 or 30 year term. That means, if you pay the stated amount every month for 30 years, the mortgage and associated payments will be completely paid off. You’ll actually own the home and not have the risk of a foreclosure from the lender. You will have satisfied the condition of the loan.

The interest rate on your mortgage determines how much you will pay in the long run. A higher interest rate means that the cost of borrowing that money will be greater for you. People with less than stellar credit are penalized by these higher interest rates, because lenders consider them less likely to fulfill their payment obligations. This means you have some control over how much you pay for your house. If you increase your credit score, you will look like less of a risk to lenders.  The less-risky version of you will have a lower interest rate and pay less.

All of that makes sense to me.

Basis Points are strange to me.

I know they exist, but I don’t understand what they have to do with my life. When I googled Basis Point, I got the following result:

“In addition to the interest rate, the lender could also charge you points and additional loan costs. Each point is one percent of the financed amount and is financed along with the principal.”

And also this definition:

“A basis point is a unit of measure used in finance to describe the percentage change  in the value or rate of a financial instrument . One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form. In most cases, it refers to changes in interest rates and bond yields.”

Why are mortgages stated this way? Why have an interest rate of 3.375% plus the ability to buy basis points? Why not just state the entire interest rate in one blow? It seems unnecessarily complicated to me.

One example I found explains that a way average consumers encounter basis points is during the lock-in period for a mortgage with your loan officer. She guarantees a certain rate at closing, which will be sometime in the near future, but not today. You are charged 50 basis points to lock in the rate. That is you are charged one-half of 1 percent of your mortgage loan balance to guarantee the interest rate you agreed upon. To me, it looks like an interest rate of 3.50% with fifty basis points ends up being a interest rate of 4.0.%. Am I wrong?

It also looks like a basis point can be known as a discount point. A discount point is a way to pay for a lower interest rate. I don’t really understand how this is different from a higher down payment, even with the following explanation.

“Discount points are a form of prepaid interest by which you pay the bank an upfront fee in exchange for it lowering the rate. The amount you can cut your loan’s rate will vary depending on how many points you pay and on how your bank underwrites it, but assuming that paying one point, or 1 percent of the loan’s balance, will lower the rate by 25 basis points.”

What do you wish you understood about basis points before securing your first mortgage? Is my understanding, or lack of understanding, off?

 

Author: ZJ Thorne

Lesbian on the path to Financial Freedom

  • Patrick

    I’m not an expert, but I’ve been through the process a few times so maybe I can point you in the right direction.

    I think the strange financial-industry terminology might be confusing you.

    To simplify: a “Basis Point” is just a more precise measurement of an interest rate to make it easier for people in the financial industry to talk about small changes in the rate. Rather than say “the interest rate has increased 1/4th-of-one-percent from 3% to 3.25%” someone might say that “the rate has increased 25 basis points.”
    Or you might see a headline about mortgage rates that says “Average 30-year interest rates edged up 4 basis points this week” which would describe a very small change, but one that might matter a great deal to an investor or bank.

    “Discount points” on the other hand, more colloquially known as “points,” are a way to buy a cheaper rate on your mortgage by paying some amount of money up front, expressed as a percentage of the total loan.

    You wrote: “To me, it looks like an interest rate of 3.50% with fifty basis points ends up being a interest rate of 4.0.%. Am I wrong?”

    What you are describing is paying a half-point on your loan at the closing table to get a 3.5% interest rate on your loan, but remember that the 3.5% is “per year” for the life of the loan and the half-point you are paying is a one-time expense. So it is dramatically different than a 30-year mortgage at 4%.

    As a practical matter, your choice would probably look something like this:
    – a rate of 4%, no points, or
    – a rate of 3.5%, with 2 points (e.g. $2000 for a $100k loan)

    Which one you would choose would depend on any number of factors, like:
    – how long you planned to stay in the house
    – how much money you had available
    – other compelling uses for $2k in your life, etc.

    I’m sure others with more knowledge will chime in soon; in the meantime, I hope this helps!

    • That’s really helpful. Thank you for clarifying this for me.

      A easier way to talk about small changes that impact big businesses more than me.

  • Oh man, I’m glad you’re talking about all this on your blog because it brings me back memories of

    the steep learning curve when I bought my first condo. You’re smart to do the homework well in advance.

    Patrick’s response is really great and is totally accurate. You don’t need to really worry about “basis points” as a borrower. Discount points are where the action is.

    Discount points feel like a bigger down payment, and in a way they are, but it might make sense to take that on in order to reduce your interest rate if you plan to stay in the house (and not refi) long term. Generally speaking, loans held for a short term are not worth paying points, and loans held for long term might be worth paying points.

    When you get to the point where you’re comparing actual interest rates and evaluating discount points, let me know and I can help you run amortization schedules to show you when the payoff point will happen. That might help you decide whether the points are worth it or not.

    • I’m so glad I don’t truly need to worry about them.

      A long term place to live is what I am aiming for. Good to know that discount points may make sense then.

      I will absolutely hit you up about amortization schedules. Thank you!