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To Pay Points Or Not To Pay Points?

Hamlet; Act 3, Scene 1

That is a question I have heard for all my years in the mortgage business.  There is no black-and-white answer to this question; hence, the reason for the discussion today.

Let’s begin with a definition of “points.”  First the expression “points” is a shortened version of the more technical name “Discount Points.”  Discount Points will help you better understand the conversation.  One point is equal to one percent (1%) of your mortgage amount.  (One point on a $300,000 loan equals $3,000; two points equals $6,000…and so on.)  The points paid will discount (or lower) the interest rate on your mortgage.  (As a guideline, each point you pay will reduce your interest rate approximately .25%.)

You see, lenders look for a particular yield on their money lent; and yield is a combination of interest rate and points.  In so far as the points paid at closing give the lender an immediate return on their loan, they need to be factored into the total yield they are receiving.  As an example, if you pay two points ($6000) on that $300,000 loan, the bank really only lent you $294,000, correct?  Yet, they are collecting payments on the full $300,000.  To “even it out,” they discount the rate to keep the total yield the same.

Because Discount Points are a factor in your interest rate, they are considered “prepaid interest.”  As such, they are tax deductible in the year in which they are paid when you purchase a home.

Many borrowers choose NOT to pay points for two reasons.  One, they don’t have the extra cash necessary.  Or two, someone advises them against it.  Yet there are times when paying points is a good idea.

  1. It may be the only way to qualify for the mortgage.  One major factor in your mortgage approval is the ratio of your new mortgage payment to your monthly income.  Lower rate, lower payment, lower ratio, and a stronger chance of approval.
  2. Sometimes you negotiate a home purchase wherein the seller is paying a percentage of the sales price towards your closing costs, as an inducement for you to buy their home.  There are times when you don’t have enough closing costs to use up the entire concession.  In those instances you would be wise to use whatever monies are available to get a lower rate (and get an additional tax deduction) rather than not take the money the seller has committed to giving you.
  3. Another time I advise clients to consider paying points (if they have the cash available) is when they close towards the end of the year.  Why?  Because they can file their tax returns and get their refund back sooner.  Spend $6000 in points and be in a 25% tax bracket and you will get $1500 back.  You get the buying power of $6000 and it really only cost you $4500.
  4. This one is almost never discussed.  If you are buying a home with an FHA mortgage, one of the most attractive (and less realized) features of the loan is that when you want to sell your home, an FHA loan is assumable.  That means your purchaser, if they qualify, can just take over your mortgage with almost NO CLOSING COSTS!  And if you believe, as all the experts do, that interest rates will be higher in the future, your buyer gets your interest rate.  This combination (of lower payments and low closing costs) makes your home more desirable than other homes and will get you a higher price!  So logic says a lower rate now may get you a better price later.

On the other hand, you do need to consider how long you intend on being in the home.  In our example, (two points on a $300,000 loan), you will likely get an interest rate discounted about one-half of one percent.  Let’s say 6% and No Points is equal to 5.5% and Two Points.  Your monthly Principal & Interest Payment at 6% would be $1800, at 5.5% it would be $1701….a savings of about $100 a month.  However, remember you spent $6000 to save that $100, so it will be sixty payments (5 years) until you break even.  Depending how long you intend to occupy the home, it may or may not be fiscally wise to pay the points.

There are many things to consider.  It’s yet another reason to work with a top loan professional.


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2 replies
  1. Phil Osborne
    Phil Osborne says:

    Dean, good article. Only problem with the analysis at the end is that you are taking into account monthly cash flow without factoring the amortization schedules. When analyzing savings you must account for the amortization differences especially at a higher loan amount of 300k. In 5yrs (60 months) the loan balance for the borrower who paid the points would be $277,382…if they applied the $100.00 a month towards principal (not a good idea in most cases—but none the less you must account for the savings) the loan balance would be $270,000 or if they didn’t apply towards principal and saved it at 0% ROI they would have 6k in the bank. In 5yrs (60 mos) for the borrower who didn’t pay the points their loan balance is $279,163 a difference of approx 2k-9k depending upon how the borrower handled the cash. Point is when doing the analysis be sure to include the amortization not just the savings per month x the number of months b/c it doesn’t give the client a true picture of where they will be 3,5,7 years down the road. We don’t usually encourage the payment of points b/c it affects the liquidity of cash, but if you look at it from a balance sheet perspective paying points on higher loan amounts will payoff in usually 3yrs. Good job on the article, appreciate it.

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