What are “points” and when should you use them?
Mortgage interest rates are available in a wide range each day, and like items on a shelf in a store, they have a price tag attached to them. The lower the rate is, the higher the cost to secure that rate. The higher the rate is, the lower it costs – until it actually starts giving back a rebate. These costs are calculated based on the amount of the loan and a percentage factor referred to as a “point”. If a certain rate has 0.500 points attached, then you will pay 0.500% of your loan amount in order to receive that rate.
Why would anyone choose to pay to buy a lower interest rate?
It’s all about maximizing your savings over the term of the loan and recouping your investment into the rate. Consider this scenario:
A $350,000 loan at 4% for 30 years will cost $601,543.27 in total.
A $350,000 loan at 3.75% for 30 years will cost $583,525.65 in total.
That’s a difference over the life of the loan of $18,017.62.
If you had to pay 1 point to buy 3.75%, then you will have invested $3,500 upfront to net $14,517.62 in savings.
What you also have to consider is the time it will take you to recover the money you paid up front. If you aren’t going to keep the mortgage long enough to recoup your costs, then it doesn’t necessarily make sense to buy the lower rate. The primary way to recoup your costs is the difference in monthly payments:
The 30-year loan at 4% has a monthly payment of $1,670.95 for principal and interest.
The 30-year loan at 3.75% has a monthly payment of $1,620.90 for principal and interest.
This means you will be recouping your $3,500 each month $50.05 at a time and will break even when you are approximately 70 months into the loan. If you don’t foresee having that same home with the same mortgage for at least the next 5.8 years, then you’re not going to realize a return on your investment into points.
In a low-interest rate environment like the one we are enjoying right now, buying the rate down now can act as a hedge against having to refinance again in the future. Whenever you refinance, there are costs incurred to close the transaction (whether you pay them out of pocket, roll them into the loan, or they are covered by rebate from a higher rate). By paying points to secure the best rate that’s available, you can avoid the temptation to refinance every time the market dips.
Cash flow is another reason to consider buying points. That doesn’t sound like it should make sense, but if you need to achieve a certain monthly payment in order to qualify (based on your debt to income ratio) paying points and getting a lower rate and payment can help you there. In a home purchase where the seller might be willing to cover some of your closing costs, lenders count points paid under seller-paid costs. Even if you pay them yourself, at least they’re still tax deductible (at the time of writing). In a refinance, you have the option to roll points into the new loan balance and basically use available equity to buy the lower interest rate.
Interest rates aren’t a one-size-fits-all proposition, so be sure to evaluate several different options based on how long you plan to have your mortgage and just how much you would have to pay upfront to see a return on your investment. You’ll also want to bring your new mortgage documents to your tax professional that following tax season so they can see about any new deductions or write-offs.