Pay the Points?

Typically, American mortgage lenders will offer potential borrowers a menu of loans, each of which bears an interest rate and an extra amount of "interest" that the borrower must pay at the inception of the loan. This extra prepaid interest is generally referred to as "points" and is computed as a stated fraction of the initial loan balance. The menu generally permits the borrower to "buy down" the interest rate by paying points. If the borrower thinks he or she will hold the underlying real estate for a long period, it is often a good idea to pay points. On the other hand, if the borrower thinks he or she is likely to sell the underlying real estate in the near future, points are often not a good idea.

This Demonstration permits you to compare two loans with different interest rates and points and to determine the conditions under which one is superior to the other. You can select the amortization period of the loan, "q" (the fraction of time into the loan when the underlying asset is sold and the loan is thus accelerated), and the rate of interest you can earn on money you invest. The Demonstration responds with a contour plot that shows the discounted value of the cash flow that results from each of the proposed mortgages. In general, locations in the lower left of the contour plot are better for the borrower than locations in the upper right. By moving the locator objects in the contour plot, you can control the interest rates and points of the two loans under comparison. The locator object colored green is better for the borrower than the one colored red. The Demonstration also produces a grid summarizing the situation.