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What's the Point of Paying Points?

Part I: New Study, Old Practice

A recently-released joint study by a Freddie Mac economist and a Professor at Penn State tried to shed some light into an age-old subject: Is there any value in paying points to 'buy down' the interest rate on a mortgage?

The study looked at loans which were originated a number of years ago and followed the loans until they defaulted, were refinanced, or otherwise terminated (or continued). After a lot of data manipulation and complicated math, the gist of the survey said that borrowers who pay points fail to keep the loan long enough to obtain any benefits from doing so.

What are points? Technically, points are a prepayment of interest in the form of a percentage-based fee. Prepaying the interest on the loan at closing essentially swaps up-front cash for a lower contract interest rate for the borrower. The lender benefits by receiving some immediate return of interest rather than seeing it trickle in over time. In their purest form, these are actually known as "discount points", since paying them has the effect of discounting the interest rate a little. For the purpose of this discussion, we're not talking about the kind of points known as an origination fee. Regardless of the name, each full point is equivalent to 1% of the loan amount you are borrowing.


Part II: Effect on Rates

Since each point paid costs 1% of the loan amount, the dollar amount can add up quickly. As we said in Part I, paying discount points lowers the interest rate on the loan. To determine just when you'll get your money back, you'll need to calculate the monthly payment on a loan with points versus a loan with no points (or you could, for example, compare a loan with one point versus 2 points, etc.). The dollar cost of the point is then divided by the difference in the monthly payment between the two loans, and the number returned is the number of months it'll take just to get your initial outlay back. Thereafter, you begin to save money.

A critical assumption in the study was that on average, paying points failed to reduce the interest rate by much. By the study's reckoning, the interest rate was reduced by only an average of 0.043% to 0.119%, which of course means it will take a long time to recover any costs. The study also only looked at fixed rate mortgages.

HSH's surveys of prices puts the gap much wider than that: presently, a 30-year conforming FRM at zero total points has an average rate of 6.23%. With one total point, the 30-year FRM averages 6.01%. Conforming 3/1 Hybrid ARMs show a slightly wider differential: 6.13% with zero points and a one-point loan at 5.88%. Of course, differentials can vary from product to product as well as from lender to lender. These discounts can also fluctuate with market conditions and investor demand for given products.

In certain market conditions, commitment periods too can change the influence of points on the rate you'll pay. The above 30-year fixed with a 30-day commitment period at zero total points has an average rate of 6.21%, while a one-point rate for 30 days is 5.98%. The same loans, but with 60-day commitment periods see average rates of 6.24% and 6.02%, respectively.

It's also not well known that point discounts aren't linear; the first point you pay may lower the rate by a quarter percentage point (for example), but the next may not have as pronounced an effect on the rate. (And you can't eradicate a market interest rate of 6% by paying 24 points, either.)

When interest rates are 'high', points are often paid to lower the interest rate for the purpose of making it easier to qualify for the loan. Qualification applies your gross monthly income against a potential monthly payment, which of course is produced by the amount of money you wish to borrow applied against a given interest rate. The lower the rate, the smaller the payment; the smaller the payment the easier it can be fit into a given budget.

There are also times when you can find 'negative points' being quoted. This is formally known as 'rebate pricing', where some portion of cash is returned to the borrower in exchange for a higher-than-market interest rate. You are also more likely to find that price quotes for smaller loan amounts require the payment of a point or points, as the lender seeks to recoup some costs of making the loan. After all, it's just as much paperwork for a $30,000 loan as a $300,000 loan, but the $30,000 provides the lender with much less return for the same amount of work.


Part III: Payback's a rhymes-with-snitch

The overarching assumption of the survey was that borrowers largely fail to realize any return for their payment of points. However, it's not clear that paying points is always a decision made by the borrower. Instead, a lender may present a borrower with a price which sounds acceptable to them -- one that is structured to meet a desired monthly payment (usually, one for which the borrower can qualify) that includes the payment of a point or partial point. The borrower may not consciously decide to pay that point at all, but merely accepts it as a matter of course for getting the home they wish.

Even if the decision is rational ("I'll pay a point to lower the rate"), paying or not paying points is absolutely a reflection of available market conditions at the time the loan is obtained. The study acknowledges that the period studied includes some of the lowest interest rates in recent times, and of course loans will be refinanced if conditions are favorable. A borrower who paid a point to get an interest rate of 7%, for example, would probably be glad to refinance to 5.5% even if it means "throwing away" the money spent on the point in the first place, because the benefit of the new lower monthly payment will far outweigh any cumulative benefit paying the point would have provided. Even if the interest rate gap is narrower, and unless the borrower's time horizon is quite short, the new loan's lower payment may provide a considerable benefit.

Here's a convoluted example of point costs and benefits. With a $100,000 loan amount, a borrower is presented a choice: An interest rate of 7% with a one-point fee (Loan 1) ($1,000) or a rate of 7.25% with no fee (Loan 2).

Monthly payment for Loan 1 at 7% is $665.30; for Loan 2 at 7.25% it is $682.17 - a difference of $16.87 per month. The gross 'breakeven period' between Loan 1 and Loan 2 in this case is just over 59 months ($1,000 divided by $16.87 = 59.28 months).

After 24 months, a market interest rates have fallen to 5.5%, so a considerable refinance opportunity has presented itself.

Over that period of time, Loan 1 (where the point was paid up front) has paid $13,862.20 in interest, while Loan 2 at the higher rate has seen $14,363.96 in interest. The difference in lower interest cost for Loan 1 is $501.75, so 50% of the $1,000 point cost has been recovered already.

In addition to a lower interest rate improving interest cost, it also causes each fixed monthly payment to contain slightly more principle. After two years, the point-paying Loan 1 with a 7% rate has a remaining balance of $97,894.94, while Loan 2 with a 7.25% rate still owes $97,991.73. This produces an additional equity benefit to Loan 1 to the tune of $96.79 -- making the cumulative difference to the Loan with a point now $598.58. As a result, almost 60% of the initial $1,000 outlay has been recovered as we come to a refinance chance.

                     Loan 1       Loan 2
Loan Amount          $100,000     $100,000
Rate                 7.00%        7.25%
Points               1.00         0.00
Point Cost           $1,000       $0,000
Payment              $665.30      $682.17
Difference           $-16.87      n/a
Breakeven            59.28 mo
($1,000/$16.87)

After 24 months

Interest Cost        $13,862.20   $14,363.96
Interest Savings     $   501.75   n/a
Remaining Balance    $97,894.94   $97,991.73
Balance differential $    96.79   n/a

Total Recovery
of $1,000 outlay
after 24 months      $   598.58   n/a
                     (about 60%)

Both loans are refinanced. Unless their time horizons are quite short, measurable improvement in cash flow for both can be obtained with a refinance, ranging from about $110 to about $125 for our pair.

Loan 1 (where the point had originally been paid) refinances a new loan of $97,894.94 at 5.5%, which produces a new monthly payment of $555.83, and the new loan is slated to charge $102,206.30 in interest cost over the life of the new loan.

Loan 2, where no points were paid, remortgages a balance of $97,891.73 and obtains a new monthly payment of $556.38, with a total interest cost of $102,307.35 over the next 30 years.

Refinance at 24 months

                     Loan 1       Loan 2
Loan Amount          $97,894.94   $97,991.73
Rate                 5.5%         5.5%
Payment              $555.83      $556.38
Difference           $  0.55      n/a
Total Interest
Cost, 360 months     $102,206.30  $102,307.35

Interest Diff.       $    101.05  n/a

Total Recovery
of $1,000 outlay
after two loans      $   699.63   n/a
                     (about 70%)

It's important to note that if Bob needed to pay that point so he could lower the rate enough to qualify for that loan, all the math above is irrelevant -- he paid it because he had no choice.

This leaves us with an interesting question. If refinancing can so improve the borrower's position (cash flow, etc.), does it really matter if the costs incurred for points are simply lost as a result of a refinance, when the benefit of refinancing (in this case, by $1300 per year or more) is so appealing? Should a borrower stick it out in their original loan for a while longer simply to recover the cost of the point?

If the borrower were to hold out for a refinancing chance after three years instead of after 2 years, the difference in remaining balances and total interest cost over that time is $900.22, leaving out any benefit garnered over time from a refinance. The question would become mostly moot, since over 90% of the upfront cost would already have been recovered. However, who knows what market conditions might be a year from today? By waiting to recoup more of that upfront cost, the opportunity for real savings over time may be lost.


Part IV: Points When Rates Are High, Points When Rates are Low

Generally, it's more common to see borrowers paying points when rates are high. Typically, what makes a rate 'high' is more a matter of perception than some arbitrary number. Context matters, too. A 7.5% interest rate would seem exorbitant to today's borrowers, but borrowers in 2000 would have leapt at the chance to get them when rates were in the mid-8% range.

In the 1980s, mortgage prices were commonly quoted at two or even three points, a consequence of interest rates in low-, mid- and even upper-double digits. Most borrowers needed to pay points to qualify for a loan.

In fact, until the 80s, points didn't exist in the world of low, stable rates. When interest rates grew like Topsy (the prime rate exceeded 20% at one point), mortgage rates bumped up against usury ceilings, which placed an upper limit on loan rates. In a state with a 15% ceiling, lenders couldn't legally make loans at 16%. By charging one or more points, the contract would be legal. Absent points, mortgage money would simply have been unavailable. Points not only helped borrowers to qualify for a loan, but also ensured a continued supply of mortgage money -- while allowing lenders to make a profit.

As well, because home prices and loan amounts were lower, even paying two points on an $80,000 loan meant a cash fee of only $1,600; today, though, two points on a $500,000 loan means ten grand in cash, up front. It's a good thing that rates are low enough as to no longer require the payment of points, but some borrowers who can choose may opt to pay points anyway.

Why would borrowers choose to pay points if they don't need to? It depends upon the discount available on the loan and the length of time you'll remain in the loan. The study referenced in Part I explicitly suggests that borrowers fail to remain long enough to get their money back. That may be true, or not, but when interest rates are 'high', paying points may become more of a need than a desire. You may need to pay points when rates are high in order to meet your budgetary goal and get into a home.

But what about when rates are low? Should you consider paying points even if rates were at, say, 5% today? You might consider buying down the interest rate to even lower-than-historic levels -- provided you've got a clear sense of the cost of the points and your breakeven point. For the most part, if we're near lows not seen for a long period of time -- one, two or even four decades, which is what happened in 2003 -- it's a fair bet that significantly lower rates won't come along in the future, making a rate-and- term refinance quite unlikely. However, should you decide to move or even do a cash-out refinance, not only will the money you spent on points be gone, but you'll also likely find that the only rates available for your new mortgage might far exceed what you are presently paying. Would this tie your hands at a future date? It's hard to say. Of course, many borrowers opted for the other method: pay no points and few if any fees, and refinance at 'no cost' every time rates slipped (and between 2002 and 2004, that happened frequently).

Whether either method makes sense for your budget depends solely upon you. Suffice it to say that borrowers have rarely had an appetite for paying points voluntarily, and when market conditions are such that they don't need to pay them, they generally don't. In 2003, if it was still common to pay 2+ points, average interest rates would have been way below the 41-year low watermark of 5.37% (which carried an average 0.36 points, by the way).

It is safe to say that the longer you stay put in a given loan, the more you'll realize 'savings' from the points you pay. However, you cannot ignore market conditions and eschew refinancing if conditions warrant.

Points in Purchase versus Refinance Transactions

Aside from all the above, there can be tax consequences for the borrower from paying points, because points are treated differently by the IRS depending upon whether the loan is for a purchase or a refinance. For a purchase transaction, any points paid are directly and fully deductible in the tax year in which you paid them. Points paid as part of a refinance transaction, however, must be prorated over the term of the new loan (i.e. one-thirtieth can be deducted as mortgage interest the first year, one- thirtieth the second year and so forth... but should you refinance again, the remainder is accelerated in the year you refinanced, then any new points you pay are pro-rated again). Therefore, depending upon your tax situation, it may or may not make sense for you to pay points on a purchase or refinance, but doing so may provide some ancillary tax benefits, especially in the case of a purchase transaction. We recommend that you consult a tax advisor to see the end benefit before you spend the cash.


Part V: A Pointless Summary

Since you've read this far, you now know that deciding to pay points isn't always a rational decision. In fact, there may be no decision at all -- it may just be a matter of accepting an offered price package which works for a borrower. In this article, we have tried to provide a wide-ranging look at points, but we treated all the examples and concepts as though the points were paid in out-of-pocket cash. That still leaves the topic of paying the points by adding their cost into a new loan amount; this is more common for refinance transactions as a kind of minor cash-out-refinance. But we'll leave the discussion of the "capitalization of point costs" for another day.

As well, there certainly are instances where borrowers may wish to pay points to get a lower rate but lack the cash to do so, and still others where the cash is readily available but the borrower just doesn't want to lower the interest rate further.

When a choice is available, a borrower will need to have a clear sense of both the costs and potential benefits of plunking down that cash today, as opposed to paying it slowly over time. Pay points and close out the loan before breakeven, and you're left with losses; pay no points and stay too long, and you end up with higher total costs and possibly less available equity, too.

There may be situations where accepting an even higher interest rate than market and getting back some cash at closing will work to your advantage, too... and that higher interest rate may make it somewhat more possible to refinance later on. Conversely, a long time horizon might see you considering paying even more points to get an interest rate you may not see again in your lifetime.

Don't forget about the tax situation, too... but that's also another article.

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Copyright 2010, HSH� Associates. All rights reserved.
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