All About Points
Points are up-front interest. Lenders charge points as a way of being paid for the work and expense of processing and approving your mortgage. When you buy a home, the points are tax-deductible – you get to claim them as an itemized expense. When you refinance, in contrast, the points must be spread out for tax purposes and deducted over the life of the new loan.
Lenders quote points as a percentage of the mortgage amount and require you to pay them at the time you close on your home purchase. One point is equal to 1% of the amount that you’re borrowing. For example, if a lender says the loan has two points, that simply means you must pay 2% of the loan amount as points. On a $120,000 loan, two points cost you $2,400.
The interest rate on a fixed-rate loan has a direct relationship to that loan’s points. When you are able to (or desire to) pay more points on a mortgage, the lender should reduce the ongoing interest rate. This reduction may be beneficial to you if you have the cash to pay more points and want to lower the interest rate that you’ll pay year after year. If you expect to hold onto the home and mortgage for many years, this is a good deal!
Conversely, if you want to (or need to) pay fewer points (perhaps because you’re cash-constrained), you can pay a higher ongoing interest rate. The shorter the time that you expect to hold onto the mortgage, the more sense this strategy of paying less now and more later makes.
Don’t get suckered into believing that “no-point” loans are a good deal. There are no free lunches in the real estate world. Remember the points/interest-rate relationship: If you pay less in points, the ongoing interest rate will be higher. So if a loan has zero points, it must have a higher interest rate. This does not necessarily mean that the loan is better or worse than comparable loans from other lenders. However, lenders who aggressively push no-point loans aren’t usually the most competitive lenders in terms of pricing.
Want to know how this shakes out in terms of your bank account?
Suppose you want to borrow $150,000. One lender quotes you 7.25% on a 30-year fixed loan and charges one point (1%). Another lender quotes 7.75% and doesn’t charge any points. Which offer is better? The answer depends mostly on how long you plan to keep the loan.
The 7.25% loan costs $1,024/month compared to $1,075/month for the other mortgage. You can save $51 per month with the 7.25% loan, but you’d have to pay $1,500 in points to get it.
To find out which loan is better for you, here’s a formula:
Divide the cost of the points by the monthly savings ($1,500 divided by $51 equals 29.4). This gives you the number of months (in this case, 29.4 months) it will take you to recover the cost of the points.
The 7.25% loan costs 0.5% less in interest annually than the other loan. Year after year, the 7.25% loan saves you 0.5%. But, because you have to pay one point up front on the 7.25% loan, it will take you about 30 months to earn back the savings to cover the cost of that point.
So, if you expect to keep the loan more than 30 months, go with the 7.25%, one-point option. If you don’t plan to keep the loan for 30 months, choose the no-points loan.
To make a fair comparison of mortgage from different lenders, have the lenders provide interest rate quotes at the SAME point level. Ask the mortgage contenders to tell you what their fixed-rate mortgage interest rate would be at one point. Also, make sure the loans are of the same term – for example, 30 years.
