You have your new house under contract at a great price and now need to arrange for a mortgage. Your bank may offer you the option of paying “points” in exchange for a lower interest rate. So, what exactly are points? Furthermore, when should you consider paying them?
A mortgage point is simply 1% of the loan amount. For example, if the mortgage is $300,000, one point would be $3,000. In exchange for paying the lender $3,000 up front, you will receive a lower interest rate (typically one-eighth or one-quarter percentage point lower) during the term of the loan. Let’s look at an example of how this works and how to determine if paying points might be beneficial.
In this example, assume that the purchase price of the home is $300,000 and the bank is willing to lend you $270,000 for 30 years at an interest rate of 4.5%. Alternatively, the bank also gives you the option to pay one point in exchange for a lower interest rate of 4.25%. Which offer makes the most sense? As we will see, it depends.
Begin by considering the initial offer of a $270,000 mortgage for 30 years at a 4.5% interest rate. With this mortgage your monthly payment would be $1,368 and the loan would be completely paid off in 30 years.
Next, determine what the monthly payment would be if you were to pay the points. In this case, you would pay one point at a cost of $2,700 (1% of the $270,000 mortgage amount) up front. The initial loan amount would be $270,000, but the interest rate would be 4.25% for 30 years instead of 4.5%. As a result, the monthly payment would be $1,328 instead of $1,368.
Now what? Paying $2,700 up front in points will save you $40 per month. Next, consider the “payback period” which is simply the number of months it will take to recoup the $2,700 you paid up front. In this example, it is 67.5 months ($2,700 divided by $40), or approximately five and one-half years. Therefore, if you expect to move again in less than five and one-half years, you will not have adequate time to recover the money you paid in points. However, if you plan to remain in the home for a longer period of time, paying points would make sense.
Of course, there are other considerations to keep in mind. Even if you plan to live in the home longer than the payback period, you may have better uses for the money you would pay in points. You could use the money to fund the down payment, which would be particularly beneficial if the extra down payment results in the avoidance of mortgage insurance. You could also use the money to pay for needed repairs or put it into an “emergency” fund.
Mortgage points are an important, but sometimes confusing, concept to understand when considering your financing options. Just remember that the key factors to consider when deciding whether or not to pay points are the amount you will save each month and how long you anticipate living in the home. If you anticipate living in the home longer than the payback period, then paying points may be a wise decision.