Paying Points to Buy Down the Rate on a Loan

Many buyers are perplexed by the concept of points.   While some lenders abuse points and use them to overcharge uneducated buyers, the concept of paying points to buy down the interest rate for the purpose of saving money is hardly predatory.  Some loans may require at least one point to be paid because of reasons such as high risk factors or low loan amounts (or both), but most buyers with excellent credit who are purchasing a primary residence have the option of paying points to obtain a lower interest rate, which could save thousands of dollars depending on how long a buyer keeps the home.   

But when does it make sense to pay points?  Since points are essentially a fee that a buyer pays for the privilege of a lower rate (and thus a lower monthly payment), the value of this savings can only be evaluated over TIME.   There's usually a very simple formula for determining if it makes sense for a buyer to pay points or not:  On a 30 year mortgage, the break even point is almost always around five years.   

There are two main factors to consider:  The total COST of points and the MONTHLY SAVINGS that results from the lower interest rate.  One POINT is typically equal to one percent of the loan amount. 

First, let's discuss exactly how much of a rate discount a buyer gets for paying a point.  Typically it's about .25%, but that's not ALWAYS the case.  It depends on how the mortgage-backed security market is trading on any given day.  But for the sake of simplicity, let's assume that one point will buy down the rate by .25% and let's use a $100,000 fixed rate 30 year mortgage as an example:

 So in this example, a buyer has THREE options: 

1) paying 2 points for the right to save $31.37 per month on their monthly payment

2) paying 1 point for the right to save $15.78 on their monthly payment, or

3) paying no points and paying a higher monthly payment than the first two options. 

NOTICE THAT regardless of whether the buyer chooses to pay one or two points, the "break even" point is a little more than five years (64 months) on both scenarios.  So a buyer must ask the question "How long will I stay in this house and keep this mortgage?"

Now let's look at the breakdown over time:

As you can see, the benefit of paying points is most evident over a long period of time.  If a buyer were to pay two points and then sell the house in three years, they would lose money.  And likewise, if a buyer insisted on not paying any points and kept the house for 20 or 30 years, they would lose several thousand dollars over the life of the loan (assuming, of course, they kept the SAME LOAN and didn't make extra payments and pay the loan off early).

So the benefit of paying points depends entirely on how long a buyer keeps the mortgage.  While that $9,293.20 figure might look tempting, remember that the vast majority of people rarely keep a home for a full 30 years.  And if they do, they may pay off the loan early. 

While people rarely ever fit into a certain category, I've broken down some various examples of buyers and what they should consider:

• Retirees or "empty nesters" who are buying a home and don't plan on moving again for the rest of their lives should consider the benefit of paying points to save money over the long term.
• Younger couples buying a "starter home" and plan to start a family should consider an option with no points.
• People that are not sure how long they will live in a particular home are better off taking an option with no points or just one point, rather than gambling on the prospect of saving money over the long run.  On average, people move about every seven years, and there's little benefit to taking either option if you fall into the "average" category since the break even point is around five years.

Way too often, many buyers get caught up in the game of getting the lowest possible rate without evaluating the true cost benefit of paying points.  And just as often, many other buyers are convinced that points are just a way for lenders to make extra money and don't consider the long term benefits of paying points to lower the payment.  Again, on a 30 year mortgage, the "break even" point to recoup the cash spent on points is usually around five years.   

Some other points to ponder:

• Contrary to popular belief, origination and discount points are both tax deductible in many situations.  Refer to IRS Publication 530 for full details.
• I used .25% as an example of how much of a discount buyers can receive for paying one point.  Although this is usually the case, sometimes a buyer can save no more than .125% or as much as .375%.  It depends entirely on how mortgage backed securities are priced in any given day.
• Loans with terms shorter than 30 years have a longer "break even" point to recoup the money spent on points.  For loans with terms of 10 or 15 years, the break even point is substantially longer, so the benefit of paying points is greatly reduced on these shorter loan terms. 
• Most loans allow the seller to pay points, as long as the seller agrees to this in the terms of the contract.  There is usually a limit of between three and six percent of the sales price as a total. 
• There is usually a limit to how many points a buyer can pay, and the cost benefit of points decreases substantially once a certain level is reached.  In other words, don't assume that a rate can be lowered 1.5% by paying 6 points.  After 2 or 3 points, the benefit has usually reached its limit. 
• Lenders may also use "premium pricing" to pay part of a buyer's closing costs.  So besides paying points to get a lower rate, buyers sometimes have the option of accepting a higher than par rate and receiving a rebate to pay closing costs.  This rebate can only be used to pay closing costs though, and cannot be received as cash back at closing.