With the Income You Need to Buy a Median-Priced Home rising - you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

With the Income You Need to Buy a Median-Priced Home rising - you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

Should I pay points to lower my mortgage rate?

Keith Gumbinger

Should I pay points to lower my mortgage rate?

money-ben-franklinThe simple answer is "Yes. No. Maybe. It depends."

As mortgage rates rise (and fall), borrowers start to wonder if it's worth paying points to lower the mortgage's interest rate. Like so many decisions involving money, there can be more than one answer; much depends upon your own circumstances. For example, if you don't have the cash (or home equity) to pay those points, the issue is decided for you, even if doing so might be beneficial.

Let's consider each potential answer to the question.

What is a point?

A point is a fee you can pay that is equivalent to one percent of the amount of the loan you are borrowing. For a $100,000 loan, each point costs $1,000. Points can also be paid in increments (e.g. a half-point, quarter-point, etc.).

In terms of mortgages, you may encounter two kinds of points. "Discount points" are a prepayment of interest and are used to lower the contract interest rate of the mortgage. You generally don't need to pay any discount points to secure a mortgage, but there may be times when it is advantageous to do so.

Then, there are percentage-based origination fees, sometimes called "origination points". These may be charged by a lender to cover the cost of granting you a mortgage, and may or may not take the place of other common mortgage fees. A lender might charge a one-point origination fee and not charge (or may reduce) other common lender fees for processing and underwriting and such. If a lender charges such a fee, you generally will need to pay this fee in order to secure a loan.

What's the benefit to paying points?

Paying a point to lower the loan's interest rate will lower the required monthly payment, and this in turn can make it easier to qualify to borrow a specific mortgage amount. This is most common in purchase-money mortgages when buying a home.

For example, let's say you qualify for a 30-year mortgage of $200,000 loan at a 3.25% interest rate (monthly payment $870). However, mortgage rates have increased to 3.5%, lifting the monthly payment to $898. Since you have only qualified for $870 per month, the higher interest rate now available means you can only borrow $193,835, and that more than $6,000 drop in borrowing power can leave you at a disadvantage in a competitive housing market. In this case, it might be possible to pay a one-point fee ($2,000) to keep the contract rate at 3.25% and preserve your opportunity to participate at a higher home price point.

While putting up another $2,000 can be challenging, the good news is that your loan now has an interest rate lower than it otherwise might, so you'll get your money back in terms of lower interest cost over time. In this case, it's just a few years.

When mortgage rates are rising, there are two ways to preserve your borrowing power. This first is to lower the mortgage rate by paying points, as in our example above; the other is to come up with a larger down payment so you have a smaller loan amount. Which is better? Is it better to have a smaller down payment and a lower interest rate, or conversely, a larger down payment (smaller mortgage amount) but a higher interest rate? The answer is: It depends on how long you end up being in the mortgage.

Using the example above, the loan with the smaller loan amount ($193,835) at the higher interest rate (3.5%) will see the borrower spend $6,163 in additional interest over the life of the loan compared to the loan with the higher loan amount ($200,000) at the lower interest rate (3.25%). Plus, instead of needing to come up with just $2,000 to lower the rate you would need to come up with more than $6,000 to make the larger down payment.

How much interest rate break do I get from paying points?

How much lower will the loan's interest rate be when you pay points? This depends on several things; the term of the loan, whether the loan is a fixed-rate or adjustable rate (and how long of a first adjustment period the loan has) and lender pricing policies. Also, reduction isn't a linear one; the amount of interest rate reduction decreases as you pay more points.

For a 30-year, fixed rate mortgage, it's pretty common to see the first point you pay reduce the loan's interest rate by about a quarter of a percentage point. However, the next point you pay may not reduce it by a whole 0.25%, but likely slightly less; expressed another way, you will likely pay more than a point -- perhaps 1.25 points -- to lower the rate by that next quarter percent. Most lenders offer point-break structures up to about 4 points, which could lower your rate by perhaps 0.75%.

On shorter-term fixed-rate loans, you are already slated to pay less interest, so a discount point (a prepayment of interest) will have less effect. On a 15-year fixed-rate loan, the first point you pay may only lower the interest rate by an eighth of a percentage point or so. Put another way, if you want to need a full quarter-percent break on a 15-year term, it will likely cost you more than one point.

Why doesn't each point you pay buy the same amount of break? Remember, you're prepaying interest. If a lender offered you a $200,000 30-year fixed-rate mortgage at 3%, you can't simply pay 12 points ($24,000) to lower the interest rate to zero. The total cost of your points needs to be pretty close to the interest you're asking the investor to forego, and the interest your loan is slated to produce for the investor funding it is many times more than $24,000. If you really want a 0% interest rate for your mortgage, well, you'll need to pay 100% of the purchase amount in cash. No mortgage, no interest.

Are there different ways of paying points?

There can be, depending on the mortgage transaction. For purchases, it's most common to pay them out of pocket, especially for first-time buyers who don't have a large down payment. However, if you do have a significant downpayment, it may be possible to trade off paying those points out of pocket by adding them to the loan amount. You'll take a slightly larger loan but get the lower interest rate.

For refinancing, it's far less common to pay points in cash; homeowners more often use a little bit of equity (called a low-cash-out refinance) or trade paying points and fees for a slightly higher-than-market interest rate (sometimes called a "no-cost" refinance, even though there are costs to be paid).

Homebuyers need to decide how best to allocate the assets they are using to buy their home. If you're trying to decide whether or not to use some of the funds you've amassed for a downpayment to pay points, you'll need to know the effect of that choice your expected costs for Private Mortgage Insurance. Use HSH's DownPayment Decisioner calculator to learn whether or not you can shift funds from place to place without increasing your PMI costs or changing its cancellation date.

Arguments for and against paying points

So should you pay points to lower your mortgage rate? We'll start with "Yes, you should pay points to lower the rate." Here are some of the situations in which you should consider paying points:

Yes, you should consider paying points, when:

You need to lower the loan's interest rate to preserve or improve your purchasing power. A lower rate means a lower monthly payment, allowing your income to carry a larger loan amount. With an $80,000 income, a 3% for 30 years will allow you to borrow about $14,000 more than a 3.5% rate will.

You want to lower the rate because you'll be there well past any "break even" point. If you can qualify for $200,000 loan at 3.5% but opt to pay a point ($2,000) to get a 3.25% rate, the difference in interest cost between the two required monthly payments means you'll get your money back after about four years, and you'll start to save interest cost and accumulate savings after that.

To see the effects of paying fees versus not paying fees when buying a home, check out HSH's FeePayBestWay closing costs calculator.

You have a target interest rate in mind for your refinance and have cash to pay points. If you need a lower interest rate to make your refi cost-effective -- widening the gap between your existing rate and a new one to a full percentage point, for example -- you can wait and hope the market will deliver what you need for free or you can buy what you need. Of course, you'll need to have the cash available to cover these costs and you'll need to remain in the new loan long enough to at least get your money back.

You have a target interest rate in mind for your refinance and have equity to pay points. A low-cash-out refinance allows you to use some equity to lower the loan's interest rate, but you'll have a higher loan balance than if you paid cash. While you don't have to have the cash on hand to pay the point(s), the higher loan balance means the savings from the lower rate come more gradually -- in this case, using the example above, it'll take almost nine years to get your money back using equity versus only six when paying out of pocket. In addition, your remaining loan balance will be higher at any given point in time.

You usually have more options for paying mortgage fees when refinancing. To see how costs for different choices work out over time, use HSH's Tri-Refi refinance calculator.

Paying points and other loan fees rarely happens in a vacuum. When buying or refinancing, you'll generally need to consider the trade-offs for allocating more funds to one aspect of the transaction as opposed to another, particularly if you are working from a finite pool of cash.

No, you probably shouldn't pay points, when:

You're taking funds from your downpayment pool. A smaller downpayment can mean a higher loan balance, and this can offset the value of lowering the interest rate on the loan. This might be a consideration if a smaller down payment doesn't mean increased costs for private mortgage insurance.

Shifting funds to paying points means you need Private Mortgage Insurance. If using some of your finite funds to pay points means you'll make a smaller down payment, triggering the need for a PMI policy, PMI costs will erase the savings from the lower rate until it can be canceled, which could be several years away. Coupled with a higher loan balance, it may be many years before you recover your outlays for both PMI and a higher loan balance.

It's not clear if you'll be in the new mortgage long enough to at least get your money back. While there can be value in having a lower monthly payment that a lower rate would bring, the object of paying points is usually to save money, and that only happens over time. If you think you'll be selling in the fairly near future -- or refinancing -- the funds you spent to lower the rate can become an unrecoverable "sunk cost". Economists at Freddie Mac and Penn State University did a study on paying points a few years back that found that many homeowners or homebuyers who pay points don't end up realizing the full benefit of the choice.

All these costs and allocations of assets interplay with one another to affect the cost of your mortgage, every month and beyond. If you're working with finite assets and trying to decide how best to balance downpayment, closing costs and PMI, you should run some calculations using HSH's DownPayment Decisioner calculator, where you can see if funds can be freed up for other purposes without moving into a higher-priced PMI bucket.

Maybe you should pay points, maybe not.

In a perfect world, you'd have unlimited cash to spread around as you best see fit. That's not the case for most people, and when you're buying a home -- especially a first home -- committing another few thousand dollars to your mortgage transaction can crimp other plans.

Even if you have the funds, you might want to hold onto them to provide a cushion for any unexpected expenses that always seem to crop up when you become a homeowner. Or, you might have designs on using those funds for furnishings or some right-away improvements or upgrades to your home. It may be that holding onto funds rather that using them to pay points will provide flexibility or opportunity that might otherwise not be available to you.

A factor that also matters here is the relative level of interest rates in the market, and of course the balance on your loan. The higher the interest rate is, the greater value you can receive from lowering the rate. Compared against a 30-year, $200,000 loan with a 3.5% rate, having a 3.25% rate will generate about $10,000 less interest cost over the life of the loan. If market interest rates were 6.5%, lowering the rate to 6.25% by paying a point lowers the total interest cost by close to $12,000 over the life of the loan. The lower that market interest rates already are, the less cost savings that lowering them even further creates.

Conversely, the higher the loan amount, the greater the value in paying points. The $200,000 loan in the 3.5% to 3.25% with a point example above saves about $10,000 in interest if paid to term. The same rates applied against an $800,000 loan amount quadruples the dollars involved, with an interest-cost differential of over $40,000 over the life of the loan. Of course, each point paid costs four times as much ($8,000) so you'll need more cash to achieve those cost savings.

Should you pay points? It depends.

Like most financial calculations, whether you should or should not do a thing depends on a number of factors. If you don't have the cash or equity available, the choice is made for you; if you do, the starting point is how much a point will cost you and how much return you will receive for having made the choice and paying the point. After that, much depends on the future (how long you remain in the mortgage or home) which can determine whether you lost money, broke even or saved money.

As noted above, lowering the mortgage's rate can make qualifying easier. Another method can be lowering the loan amount via a larger downpayment. If you're purchasing a home, you should run calculations to see if a lower rate or a smaller loan balance produces the best outcome for you. It might be easier to ask parents or relatives for a gift of an additional $2,000 (per our original example) to lower the loan's rate and help you to qualify rather than try to come up with more than another $6,000 to lower the loan balance, but your situation may allow for either choice.

Other factors can come into play, too, such as where the money to pay points comes from, and whether or not this creates a tax event for you. For example, cashing stocks to raise funds can incur capital gains taxes, and that could make each point even more costly, while also lowering your potential for future investment growth at the same time. Using up a portion of any reserve cushion you have to pay points might create sleepless nights.

Tax Implications from Paying Points

There can be at least one small benefit from paying points, but this comes with few caveats, of course. Since they are a prepayment of mortgage interest, points you pay can be deducted on your federal income taxes if you paid them out of pocket. The caveat is that to deduct them, you'll need to itemize your deductions on Schedule A, and you're only likely to do this if your itemized deductions exceed the standard deduction. Your tax professional can help guide you to the best option here.

If you pay points in a purchase transaction, the total amount is deductible in the year you bought your home.

For refinancing, though, points are treated differently. The cost of any points you pay must be prorated over the term of the loan; for example, you refinance to a new 30-year loan and pay a point to lower the rate. The point costs $2,000; you will be allowed to include 1/30th of the cost (or 1/15th of the cost in the case of a 15-year loan term).

If you end up refinancing again at some point in the future, the remaining undeducted costs can be accelerated into that tax year... and if you pay a point to refinance again, the prorate period starts all over with the new loan term.

There are some additional rules and caveats regarding the deductibilty of points. The IRS covers these in Tax Topics No. 504: Home Mortgage Points, so be sure to review these as you start doing your tax returns. The IRS makes available an interactive tax assistant to help you see how mortgage-related expense can or can't be deducted; you can find this at Can I Deduct My Mortgage-Related Expenses?

Related: Ask the Expert: How much do points affect the loan's interest rate?

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