When taking out a mortgage, whether for a new purchase or to refinance an existing loan, one decision you’ll have to make is if it’s worth paying mortgage points.
Before we get into that, it’s important to note that the term “points” gets thrown around loosely, and can refer to the loan origination fee and/or discount points.
The loan origination fee is the commission charged by the bank or loan officer for working on your loan, whereas discount points are used to buy down your interest rate.
It’s an important distinction because the loan origination charge is basically unavoidable (they need to eat, right?), while paying discount points (prepaid interest) is optional.
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Do You Want an Even Lower Mortgage Rate?
Let’s assume you’re shopping for a $100,000 mortgage.
While mortgage rate shopping, you’ll probably pay the most attention to the big, glaring rate in front of you, such as 2.99%
But if you look under that rate, or in the small, fine print, you should see more details about the rate, such as the fact that it requires you to pay two mortgage points.
[Watch out for rates you have to pay for!]
In this case, those two points are mortgage discount points, which lower the rate to that amazingly low 2.99%.
But those two points would cost you $2,000, using our $100,000 loan example, as each point is equal to one percent of the loan amount.
If you don’t want to pay those two points, your actual mortgage rate will probably be markedly higher, perhaps 3.5% instead.
And the bank or lender may inform you that you have to pay “points” to get that low, advertised interest rate on your mortgage.
Also keep in mind that the discount points are paid in addition to any lender fees charged for origination, processing, underwriting, and so forth.
Anyway, when looking at difference in payment, we’d be talking about $27 per month if you opted for the lower 2.99% rate.
When Do You Break Even?
While 2.99% certainly sounds a heck of a lot better than 3.5%, it’s only a $27 difference when you make your mortgage payment each month.
Not as awesome as it looked, eh. And guess what? You just paid $2,000 upfront, out-of-pocket for that $27 monthly discount.
And money spent today is more expensive than the same money spent in the future thanks to our friend inflation.
It’s also long gone the minute you spend it, at a time when money may be tight thanks to other closing costs and housing-related expenditures.
So why would someone want to drop a couple thousand bucks for a tiny payment reduction? Well, assuming they stick with the loan long-term, the savings will come. It’ll just take a while…
The point at which you start saving money and essentially make those points worth the cost is called your “break-even point.”
The proper break-even point factors in your income tax bracket and current savings rates, not just the difference in monthly payment.
Of course, if you invest the money in stocks or bonds or whatever else, it could shift the break-even point tremendously.
If you want a good idea of when you’ll hit this magical point, check out this calculator from Jack Guttentag.
In our example, with a tax bracket of 25% and a current savings account yield of 1%, it would take roughly 51 months to break even, or for paying points to make sense.
Put simply, if you don’t plan on spending at least four years in your home, or more importantly, with the mortgage, it’s not worth paying the points.
However, if you’re the type that wants to pay as little interest as possible over the life of your loan because you’re in it for the long-haul, paying points can be a smart move.
In fact, if you see the mortgage out to its full term, you’d pay roughly $10,000 less in interest versus the higher rate mortgage. That’s where you “win.”
In summary, there’s probably a lot of wastage when it comes to paying mortgage points.
But if you’re planning to hunker down for a while, now is a great time to pay points, seeing that rates are at all-time lows.
That makes the prospect of a refinance unlikely, unless you need to tap equity in the future. The only drawback is if you sell before realizing the benefit.
Just be sure you actually secure a lower interest rate when paying points. Those who don’t shop around could wind up with a higher rate compared to those who avoided paying points altogether.
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