When is it a good idea to pay points on a mortgage loan? This is a common question for people buying a new home, but it also comes up when an existing mortgage loan is re-financed. In general, the practice of paying "points" on a loan is fairly common and is often viewed as simply a cost of obtaining the loan. The question that people obtaining a mortgage should ask is, whether paying points is a good idea and a sound financial decision based on their specific circumstances? In order to answer this question, borrowers have to look at the mechanics of the way points are charged, and do some simple math that will make the decision much easier.
Here's the problem: Many borrowers shop for mortgage loans based solely on the interest rate, or "face rate" of the loan, and don't really pay enough attention to the APR. The difference between the two has to do with fees and costs associated with the loan that typically cause the APR to be slightly higher. Loan points can be a big part of those up-front costs. So, what is a mortgage loan "point" and how is it calculated?
A point is simply 1% of the loan amount, so on a $250,000 loan, one point would equate to $2,500 regardless of the interest rate involved. Many times borrowers will want the lowest possible interest rate, and will agree to pay points in order to get a lower face rate. Depending on the circumstances of the borrower, this may or may not be a great decision. Here are some practical tips to help you decide if this practice is right for you on your next mortgage loan:
How much money are we talking about? Convert the number of points into dollars.
How much less, in dollars, will my monthly payment be if I pay these up-front points vs. not paying them?
Calculate the "payback" period, i.e, the number of months it will take to break even on this expenditure, by dividing the cost by the amount saved per month. For example: Paying $2,500 in points to save $50/month, yields a payback period of 50 months ($2,500 / $50 = 50).
Compare the payback period to the amount of time you expect to be in the home from this point. In the above example, if you felt like there was a good chance you would be in the home for less than 5 more years (60 more months), it might not be a good financial decision to pay those points.
This is a simple example, but many borrowers never make this connection and unnecessarily pay way too much up front to close a loan. I've had some seasoned home buyers ignore this relationship in their zest to squeeze out the lowest possible interest rate, when the payback period was longer than they've ever owned a home before! Also think about the flip-side: What if you are planning to be in this new home for another 20 years? It might make sense to pay even more points up front and come out ahead over time.
In the world of real estate and home mortgages, your circumstances should dictate whether or not paying points is best for you. Knowing the payback period is just one way to help you make that important decision. If you're thinking about buying or selling a NorCal home, please feel free to contact us at 916-774-3151.