When it comes to taking out a loan, it’s important to know just want you’re getting, for how long, and how much it’s going to cost you.
To understand how much your loan is going to cost you over time, you need to understand points and rates; what they are and how much money they’ll each cost you.
Both are important, but their impact can be very different depending on how long you intend to have a loan for your project.
Before we dive into why each of these is important and what you should pay attention to, let’s talk about what both points and rates mean.
Rates refer to your interest rates – how much you pay monthly, in interest, for your loan. It’s basically the cost of borrowing money.
This is calculated by taking the total amount of your loan, multiplying it by your interest rate, and then dividing it by the number of months in a year (by 12). This is because even though you may not have a loan for a year, the rate is always quoted as an annualized number.
An example of determining your monthly interest payments would be:
You take out a $100,000 loan with an interest rate of 12%. You multiply your total loan amount, $100,000 by 12% (or 0.12). This equals $12,000.
$100,000*12%=12,000
You take that number and divide it by 12, to find out your interest payment each month. This is what you pay monthly.
$12,000/12= $1,000
Some lenders have an early payoff penalty, which means you are responsible for paying the full $12,000 whether your loan lasts 3 months or 12 months. At Loan Ranger Capital, you are only responsible for your monthly interest payments for as long as you have the loan.
Continuing with the example above: if you have a loan for four months, you will pay $4,000 in interest. Seven months would be $7,000, etc.
Now let’s take a look at points.
A point is a percentage-based fee (1 point = 1%) of the total cost of your loan, which you pay one time – at closing.
Points are paid to your lender (and, separately, to your broker if you use one).
Here at LRC we mainly deal in home flips or new construction loans which are meant to be short term. If the loan you are taking out is less than one year, an equal reduction in points will be more beneficial than in the interest rate.
What does that mean?
The points you pay are based on a one-time number at closing, whereas the interest rate is an annualized number that you pay 1/12th of each month.
If you have a flip project that lasts 6 months, you’ll only pay 6 out of 12 months of interest – so you only benefit ½ a percentage point because it’s an annualized number. Since the points are paid in a lump sum, the length of the project does not matter in factoring the out-of-pocket cost of points.
While it may seem counterintuitive, this means a 2% reduction in the interest rate would be the same as a 1-point reduction, given a 6-month term. Therefore, it’s very important to total up the total project costs before committing to a lender. You may be shocked that the lowest rate is not always the best option.
This can all seem a bit complicated, but we’re here to help you! We can answer any questions you might have. Or, if you are ready to apply for a loan just click here. We look forward to working with you!