"Points" refer to percentages of a mortgage – each point equals 1% of the total mortgage amount. They are fees paid upfront at closing in exchange for a reduction in the interest rate over the term of the loan.
Do not confuse points with down payments. An increase in down payment decreases the amount of your loan. Points reduce your interest rate, and payments are expressed as a percentage of your mortgage amount, but they do not change your mortgage amount. In essence, points are prepaid interest.
Keep in mind that paying one point does not result in reducing your mortgage interest rate by 1%. A typical drop in interest rate is between 0.125% and 0.25%.
There are three main questions to answer when considering points:
- Can You Afford the Upfront Payment? – Factor in all fees, closing costs, mortgage insurance if required, etc. to determine if you have enough funds to apply to points and still pay all your monthly bills.
- Why Do You Need Lower Payments? – Do you need to buy down the interest rate to meet a specific debt-income ratio to qualify for a mortgage? Are you stretching to meet monthly payments? Points may not be best in these cases; consider buying a smaller house.
- How Long Will You Stay in the House? – If you plan to refinance or move in the short term, you will not receive the benefit of points. You should plan to stay beyond the break-even point where the upfront payment for the points equals the collective savings from the lower interest rate. Should you hold your loan to term, it will save significant money on your total interest payments.
Calculators are available online to help you find the break-even point. Assumptions may not be the same with all calculators, so check the listed assumptions to consider whether they fit your situation.
Let's use one to test some hypothetical situations. Assume a $300,000 house with 20% down, therefore a $240,000 mortgage amount, and a 30-year fixed rate loan at 4.5%.
If one point reduces the interest rate by 0.125%, paying two points will cost $4,800 up front, and drop the interest rate to 4.25%. The break-even point is in 136 months, or 11 years and 4 months. You will save $12,740 in interest at term.
If one point reduces the interest rate by 0.25%, paying two points will cost $4,800 up front, and drop the interest rate to 4.00%. The break-even point is in 68 months, or 5 years and 8 months. You will save $25,289 in interest at term.
What if the starting rates were higher? Let's change the starting rate to 6.25% and rerun the calculations. Two points will still cost $4,800 up front. If the rate drops from 6.5% to 6.25%, the break-even point is 122 months and you save $14,127 in total interest over the life of the loan. Going from 6.5% to 6.0% makes the break-even point 62 months and saves $28,095 in interest.
This illustrates that points are more valuable when interest rates are higher – because you are saving more on the monthly payments while the upfront money stays the same.
What if your house were more or less expensive? It will not affect the break-even point; it will simply make your payments smaller or larger. Try it and see.
With some easy number crunching, you should be able to tell if points make sense for your situation. If you conclude that they do, compare offers from different lenders, and do not be afraid to negotiate. You may get a further reduction in interest rate for the same points.