If you’ve ever purchased a home or gone through a refinance, then you may have been faced with the decision of whether or not to pay points to lower your interest rate. Ultimately you have to determine if it’s worth it to pay a sometimes large fee in exchange for a lower interest rate and monthly payment.
WHAT ARE POINTS?
Let me start out by defining exactly what “points” are in case there are some readers who aren’t familiar.
A point is simply a fee that you pay to lower your interest rate. In fact, 1 point equals 1% of the loan balance. So if you were quoted a 30 year interest rate of 3.00% on a $300,000 mortgage, paying 1 point ($3,000) may reduce your interest rate to 2.75%. And paying 2 points ($6,000) may reduce it further to 2.50%. According to bankrate.com, each point you pay typically lowers your rate by around 0.25%.
A lower interest rate sounds appealing, but it comes at a cost. If your goal was to get a 2.50% interest rate it would cost you $6,000.
Is it worth it?
PEOPLE HATE PAYING FEES
I would venture to say that many people are dead set against paying fees. Many people opt for a 15 year mortgage (which in most cases is a really bad idea) instead of a 30 year mortgage because they don’t want to pay more than they have to.
Then asking them to pay points seems like rubbing salt in the wound!
And to add further insult to injury, many people would likely roll the cost of the points into their loan balance. So, not only are they paying a fee, but their mortgage balance is larger as a result, which is what many are trying to avoid in the first place. This is a major psychological hurdle that can be difficult to overcome.
A HIGHER MORTGAGE BALANCE DOES NOT EQUATE TO PAYING MORE
So, while it is difficult to overcome the idea of having a higher mortgage balance as a result of paying points, it DOES NOT mean that you will end up paying more for your mortgage. This is very counterintuitive so let me explain.
You would naturally think that a higher mortgage balance results in you paying more over the life of your loan. But it does not because in exchange for paying points (and increasing your mortgage balance) you benefit from a lower interest rate.
Using the example above, let’s go through two options.
(1) Go with a $300,000 30-year mortgage and pay no points. Under this structure your interest rate would be 3.00% and your payment would be $1,265 / month.
(2) Go with a $306,000 30-year mortgage since you paid 2 points. Under this structure your interest rate would be 2.50% and your payment would be $1,209 / month.
If you plan to be in your home for the full 30 year period, then you would have paid $56 less per month ($1,265 – $1,209). That’s about $20,000 in savings over the life of the loan. This illustrates the point that a higher mortgage balance is not always bad.
Furthermore, if you planned to stay in the home for the entire 30 year period, then you should aim to pay as many points as they will let you pay. Afterall, whether you pay points or not, your loan will still be paid off in 30 years. And wouldn’t you want to have a lower monthly payment along the way? Paying points allows you to do just that!
HOW LONG YOU STAY IN THE HOME MATTERS
At this point, you’re likely asking the question,
“What if I don’t plan to stay in the home for the full 30 year period?”
This is a very valid point and in fact I wrote a previous blog post about this.
The premise of the post is that you need to calculate the number of years you need to stay in your home to determine if refinancing makes financial sense. I call this the breakeven period.
Even though the post examined the effectiveness of refinancing, the methodology also applies if you are considering paying points for a refinance or a new home purchase.
To determine the breakeven period, you must, at various time periods (i.e. 1 year, 2 years, etc.), (1) determine how much you will save by paying points and (2) calculate the loan balance for both the pay points option and the no-points option. This can be done by using an amortization calculator online. Here is a good one from Credit Karma. Then you combine everything together.
I’ve already done the calculation and the end result is that you end up breaking even in about 5 years if you pay points. So, if you will be in the house for at least that long, then it makes sense to pay points.
Please read the blog post linked above for further info on how you can do the calculation for your unique circumstances.
So, the next time you are faced with buying a home or refinancing be sure to ask about paying points. Then using the information above (and in the other blog post) determine how long you need to stay in your home to determine whether or not you should pay points.
Feel free to share any questions or comments you have. What are your thoughts on paying points?
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