Why pay points?

When people ask whether to pay up-front "points" on a mortgage loan, it brings to mind an old motor oil ad. A mechanic is holding some worn engine parts and telling us why we should opt for the premium lubricant rather than Brand X.

"You can pay me now," he says, "or you can pay me later."

The same principle applies to the question about points. You can "buy" a lower interest rate today by paying a point or two (one or two percent of the loan amount), also known as an origination fee ("pay me now"). Or you can avoid the points today and accept a higher rate ("pay me later"). Unlike the motor oil question, this one has no obvious answer.

The following enlightened view comes from Jack M. Guttentag ("The Mortgage Professor"):

"Paying points can be viewed as an investment that yields a return that rises the longer you stay in your house. The return consists of the saving in monthly payment resulting from the lower interest rate, plus the lower loan balance in the month the loan is paid in full. This return can be compared to the return on other investments available to you over a similar time horizon."

Consider two offers for a $100,000 loan. Loan A has a lower interest rate of five percent, but you have to pay one point (or $1,000) to get that rate. Loan B has a higher rate of six percent with no points. Calculating your real return on that $1,000 investment depends on additional factors such as your tax bracket, but, assuming you stay in the home for 30 years, the annual rate of return on your $1,000 investment is better than 60 percent even after taxes. In this case the one-point fee is a tremendous investment.

The math is complicated, but the general conclusion is a no-brainer, especially when you use a mortgage payment calculator such as the one on Trulia. With Loan B at six percent interest, the monthly payments come to $599. With Loan A at five percent, they are $536. Think of the $63 monthly savings as the "return" on your $1,000 investment. Now try to think of another way to make $63 every month for 30 years by investing $1,000 up front.

This example is an illustration, and usually the advantages aren't so stark. And, had you needed to relocate and left the house after a year, your $1,000 "investment" would have been a loser. But you get the idea. When considering points, think of them as an investment and then run the numbers.

Comments

By Damian Warwick,  Wed Nov 4 2009, 12:14

With recent changes to the mortgage industry and if your are dealing with an honest Loan Offier it will always pay to lower your rate to the next .125% lower on your home loan. But you are correct, you must run the numbers.

Damian Warwick atlantahomeloan

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By Steve Kappre,  Wed Nov 25 2009, 21:15

It is interesting lately how investors have priced out loans. Often rates in multiples of .25% (5%, 4.75%, etc) have better rates/fee options. As always, just do the math, and work with a great loan officer who will explain each and every option.

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By Michael Haigh,  Wed Dec 2 2009, 22:14

Wow - I love this question...and everyone is right you have to do the math. I own quite a few pieces of property and every time I write an offfer it is for the seller to pay those points for me to buy down the loan interest rate - everybody wins, deductions all around..but it makes my investment better. The last one was a secondary residence and I was able to "buy" with the seller's money a 4.00% 30 year fixed loan. For me what makes it even better is I know the cost of borrowing money will be higher down the road.

And for my clients as long as that math supports - we are good.

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By Coast Homebuyers,  Thu Jan 21 2010, 07:35

The value of paying points depends on how long you plan on having the loan. If you think you will have the loan only a few years, it often is less expensive in the long run to take a higher rate and pay fewer (or no) points. If you plan on having the loan for a very long time, it definitely can make sense to pay points to get a lower rate. It's just a matter of running the numbers on the loan.

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By Tom Matthews & Joanne Taranto,  Fri Feb 12 2010, 05:42

Trulia Staff:

Next time you write an article about points I would hope you would take the entire country into consideration. It is fine to pay points on a $100,000 dollar place as the cost is low, but what if you are in Massachusetts buying a $900,000 dollar condo and only expect to be there for 5 years. Will your 1/8 of a point buy down be recouped in 5 years if it cost you $9,000 dollars. I just feel that your article could have had so much more power if more properly focused. Best

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By Mgkgeno,  Tue Mar 9 2010, 11:20

It also depends on how long you will keep the loan. Many borrowers take out a 30 year loan then move into a 15 year loan after they pay the loan down a bit. What you pay in closing costs is also another factor. We close most of our loans with low closing costs so if the rate goes down its easy and cheap to get into a lower rate.

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By Mortgageguy,  Sat Mar 27 2010, 19:14

My rule of thumb is the half rule on 30-year mortgages. So, if you're getting an 1/8th better in rate for a 1/4 point, or a 1/4 better in rate for a 1/2 point, or a 1/2 better in rate for 1 point, your break-even will always be between 32-33 months or just a little over two years which is a no-brainer. Here's the math. 5.25% rate on 100,000 mortgage = 552.20 for P&I. A 5.0% rate would equal 536.82 for a difference of 15.38 per month. Assume 1/2 point to get this rate or $500.00. 500.00 divided by 15.38 equals 32.51 months. Try this at any mortgage amount and any interest rate and you'll see this rule always fits. If you're evaluating the same P&I but checking break-evens, 5/8ths of a point would be $625.00 or 40.63 months to break even, 3/4rds of a point would be $750.00 or 48.76 months, 7/8ths would be 875.00 or 56.89 and 1 point would be 1,000.00 or 65 months. The most important thing to evaluate with points is break-even and whether you'll live there long enough to recoup your investment.

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By Taxthinker,  Fri Apr 9 2010, 09:54

Seems most do not consider the the tax benefits of higher interest payments (and the time value of money), particularly at certain income levels (obviously different for any given individual.) The higher the interest the greater the deduction...

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By Donn,  Thu Jul 15 2010, 08:17

The bottom line is how long do you expect to stay in the home or keep that particular loan. Don't overcomplicate it! Paying a point on your loan will probably costs thousands of dolllars and only benefits you if you stay with the loan long enough to not just break even but SAVE MONEY!!

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By Kyla,  Sun Aug 1 2010, 16:45

As a homebuyer (with a Finance degree), I did the calculation side by side and discovered that by paying several thousand dollars, I could save a miniscule amount stretched over many, many years. They use all the right buzz words: "save money over the long haul." But really you save a tiny amount of money over a very long haul, money that, as a previous poster pointed out, is deductible anyway. Points are only good for the lender. If you can get the seller to pay them, as pointed out by another previous poster, then great, but otherwise, put that money elsewhere.

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By Lisa,  Wed Sep 29 2010, 22:19

Agree with Donn and most other posters. It all comes down to how long you will stay. As for the tax deduction, you can also deduct the points paid, so in most cases paying higher interest for a tax deduction shouldn't be a consideration.

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By Shawn Hood,  Fri Feb 4 2011, 00:03

I am a mortgage broker with a Finance Degree and it all depends on how long the homeowner wants to stay in their home. You have to look at the diffence of your payment with and without points. Then you add the monthly payments and compare the amount that you paid in points. If you stay in your home long enough then it would be worth it. Here is an example on a $100,000 loan at 5% with 1 point decreasing the rate to 4.75%. The monthly payment is $536.82 at 5% and $521.65 at 4.75%. $536.82-$521.65 is $15.17 a month. The point on a $100,000 loan is $1,000 and if you divide $1,000 by $15.17 it equals the number of months it takes to pay back the point of $1,000. It would take 65.92 months to pay back the point and break even. Now if you plan to own the home longer than 66 months then it is worth it to pay the point.

Shawn Hood
Innovative Mortgage
Cell: 813-446-9695

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By Thierry Abel,  Sun Feb 27 2011, 15:09

When you buy a house, you get to deduct in one fell swoop the points paid to get your mortgage. When you refinance a mortgage, though, you have to deduct the points over the life of the loan. That means you can deduct 1/30th of the points a year if it’s a 30-year mortgage. That’s $33 a year for each $1,000 of points you paid -- not much, maybe, but don’t throw it away.
Even more important, in the year you pay off the loan -- because you sell the house or refinance again -- you get to deduct in one fell swoop all of the as-yet-undeducted points. There’s one exception to this sweet rule: If you refinance a refinanced loan with the same lender, you add the points paid on the latest deal to the leftovers from the previous refinancing -- and deduct that amount gradually over the life of the new loan.

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By Thierry Abel,  Sun Feb 27 2011, 15:16

Not only points paid for residential real estate purchase are tax deductible in the year they are paid. But the Internal Revenue Service also allows the buyer to deduct this as an expense on their federal tax returns even if the seller pays for the points at closing.

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By Don Maher,  Mon Mar 14 2011, 09:41

Borrowers should ask their lender for a mortgage analysis similar to the sample in the below link. You can see to the dollar which loan is more cost effective over a specified period of time. All "top" Mortgage Planners can provide them.

http://www.donmaher.com/docs/analysis.pdf

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By Dr Philip Johnson,  Thu Mar 17 2011, 11:01

One should also run the numbers correctly. If one doesn't pay the $1000 in points, that money could be used as additional downpayment and then one would only need to borrow $99,000, not $100,000

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By Bill Parker, CPA*,  Mon May 23 2011, 15:32

I would like to know where one can get a 1% reduction in rate for 1 Point! It is usually more like a .25% reduction for each Point...which results in an entirely different perspective on just how good of a deal paying Points really is. Of course, as mentioned by many others, any answer depends on how long the borrower plans to stay in the home.

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By Deborah,  Sat Jun 11 2011, 16:37

Thank you, Bill Parker, CPA! I was wondering where anyone could possilby get a 1 for 1 rate deduction. A better comparison is really looking at having the seller contribute to rate buydown instead of offering a lower purchase price. 9 times out of 10, the payment will be lower despite the fact the loan may be slightly larger. I have software that can break this out very quickly for either a consumer or another professional.

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By Home Buyer Help,  Thu Sep 29 2011, 11:34

Very good thoughts given here, especially the .25% reduction in rate for each 1 point paid. I was in the mortgage industry once and never saw any discount points offered at 1 for 1. I could never see the return on investment for customers. I always suggested they make 2 principal payments each month in the early years especially, this reduces your effective interest rate overall.

Also, the article in the beginning of this thread mentioned origination points as a way to buy a lower rate. That is not really correct, origination points go into the lender and the loan officers pockets and does not affect the interest rate. Just an FYI for all.

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By Kenolsen,  Thu Mar 1 2012, 10:12

I find all of the comments very interesting & helpful; however I do not want to change the focus of the thread, but I will. Nothing has been said about the P&I methodology of adding principal (like adding $100 or $200 to the monthly payment). We have retired many years ago & during our apartment complex endeavors as well as our home loans we used this method of reducing principal: How sweet it is to perform a 1031 tax deferred exchange & move onto another much more expensive property.

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By Michael Smith, MBA, MPM,  Sun Apr 15 2012, 10:58

All very strong comments here. Great job everyone! As a lender, I am all about full disclosure. I have no problem showing my rate sheet and then let the chips fall where they may.

Friday's pricing as example:

30 Year Fixed Rate (conventional up to $417,000):
This is a 15-day lock as an example

Rate Points (or lender credit)
3.99% (.875%)
3.875% .125%
3.75% 1.3750%

At a rate of 3.99%, my company, Provident Federal Savings Bank is paying the buyer or homeowner .875% points for their closing costs.

At 3.875% the buyer/homeowner is paying .125% points
At 3.75%, the buyer/homeowner is paying 1.375% points

For me, I would not advise that the client take a 3.75%. It is just not worth if for an 1/8th of a point drop in rate. I.e. on a $200,000 loan, 3.75% = $926.23 PI payment; on a $200,000 loan, 3.875% = $940.47.

So as you can see in this example, the payment savings = $14.24 a month. However the cost in points = $2,750. $2,750/$14.24 = 193 mos to break even or 16.09 years.

On the flipside, however I would go up in rate and get the lender credit. I.e. at 4.125%, we are paying 1.375% in lender credit. In that example the buyer/homeowner pays about $16 higher in monthly payment but we pay .50% higher in "rebate." That jump represents another $1,000 in lender credit on a $200,000 loan. **Points work both ways so I always look at our spread and what makes most sense for the client! :)

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