Should I consider paying points?

"Paying points is in essence a trade off
between paying money now versus
paying money later."

What are points?

Points are interest fees paid on a loan that reduce your monthly interest rate by requiring prepayment of a small percentage of the total interest due. The number of points owed is up to your lender. For instance, a one point loan will always have a lower interest rate than a no point loan. Each point equals 1% of the total loan amount.

So are points good or bad?

It depends on how long you are looking to keep the loan. We suggest paying points up front if you plan on keeping the loan for at least four years to ensure that you recoup the costs through lower monthly payments. Another benefit to points is that they are tax deductible.

However, if you think that you might move within the next four years or might want to refinance because the market rate is declining, then you probably would be better off with a no point loan.

Points are typically the largest cost associated with getting a home mortgage. Each point represents one percent of the mortgage balance, or $1,000 for each $100,000 financed. Unlike other costs, points can not be financed into your payment and must be paid with cash at the close of escrow. The most common type of points are discount points. These are fees paid by the borrower to reduce the interest rate of the loan. The more points you agree to pay upfront, the lower your interest rate will be. Deciding whether or not to pay points depends on many factors including the amount of cash you have available after making the down payment, the amount of the discount and the length of time you plan on owning the house. You'll have to take a good look at the costs and payment schedule of different types of loans to decide which one is best for you. If you do not have extra cash to pay points, but still want to lower your interest rate, there's still hope. Some sellers are willing to pay the discount points or other closing costs in order to sell the property. It's worth asking, even if you have the money to pay. If you're being moved by your company, your relocation package may have a provision to help you reduce you monthly payment.

The best way to decide whether you should pay points or not is to perform a break-even analysis. This is done as follows:

1. Calculate the cost of the points. Example: 2 points on a $100,000 loan is $2,000.

2. Calculate the monthly savings on the loan as a result of obtaining a lower interest rate. Example: $50 per month.

3. Divide the cost of the points by the monthly savings to come up with the number of months to break even. In the above example, this number is 40 months. If you plan to keep the house for longer than the break-even number of months, then it makes sense to pay points; otherwise it does not.

4. The above calculation does not take into account the tax advantages of points. When you are buying a house the points you pay are tax-deductible, so you realize some savings immediately. On the other hand, when you get a lower payment, your tax deduction reduces! This makes it a little difficult to calculate the break-even time taking taxes into account. In the case of a purchase, taxes definitely reduce the break-even time. However, in the case of a refinance, the points are NOT tax-deductible, but have to be amortized over the life of the loan. This results in few tax benefits or none at all, so there is little or no effect on the time to break even.

If none of the above makes sense, use this simple rule of thumb: If you plan to stay in the house for less than 3 years, do not pay points. If you plan to stay in the house for more than 5 years, pay 1 to 2 points. If you plan to stay in the house for between 3 and 5 years, it does not make a significant difference whether you pay points or not!

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