The Point of Points
It seems that everyone I talk with these days is either in the middle of refinancing their mortgage, or wondering if they should do so. With mortgage rates at all-time lows, it is no wonder that there is a mad dash to lock in these incredibly low rates for the long-term. As I discussed in my Podcast “Does Refinancing Your Mortgage Make Sense” back in April, just because rates are low, does not automatically mean it makes sense for everyone to refinance. It all depends on your specific goals, as well as your current loan structure versus your new potential loan structure and associated fees.
There is another issue that I want to discuss however, which comes into play when obtaining a new mortgage, or when refinancing an old one, and that is whether or not to pay “Points.” And as usual, there is no one-size-fits-all solution for this decision. So what considerations should you take into account when deciding if you should, or should not, pay points on your next mortgage?
Let’s start with a quick primer on what “Points” are in the first place. At the most basic level, points are a fee paid to the lender (i.e. mortgage provider) in order to get a lower interest rate on your loan. Paying points on a mortgage is a choice to pay more up front so that you can [hopefully] pay less in the long run. One point is equivalent to 1.00% of your loan amount, so if you have a $500,000 mortgage, and you pay one point, you are paying $5,000 extra at the beginning of your loan. For every point that you pay, your interest rate is generally reduced by 0.25% to 0.375%, although this can vary depending on your specific lender and the type of loan that you choose.
Here’s an example to help illustrate how to determine when paying points makes sense. Let’s assume you are refinancing a $500,000 mortgage and that your lender is offering you either a 30-year fixed rate mortgage at a 3.0% interest rate, or the same loan at a 2.75% interest rate if you pay one point. As we discussed above, one point on a $500,000 loan is $5,000. Now all we have do is figure out how long it will take you to save $5,000 (the amount you pay up front in order to lower your rate) or more by having a lower monthly mortgage payment.
The first step is to figure out the monthly payment for each loan. There are about a million online calculators that will do this for you, so I won’t bother with the math here. Here are the two options based on the example above:
Loan #1 (no points):
- $500,000, 30-year fixed rate at 3.00% will have a monthly payment of $2,108 per month.
Loan #2 (pay one point):
- $500,000, 30-year fixed rate at 2.75% will have a monthly payment of $2,041 per month.
As you can see, the monthly payment on loan #2 (paying one point) is $67 less than on loan #1 (paying no points). So if we divide $5,000 (the amount we paid to receive the lower loan rate) by $67 (the lower monthly cost for loan #2), we see that it takes almost 75 months (6.25 years) for our monthly savings to equal the $5,000 we paid up-front to obtain these monthly savings.
So without considering the time value of money (a dollar today is worth more than a dollar tomorrow), in the scenario above, if you think you will keep your mortgage (not your home, but this specific mortgage) for more than 6.25 years, then paying points would likely make sense. Of course, it’s not quite that simple, because you absolutely should consider the time value of money and/or the opportunity costs involved. What could you have done with that $5,000 over the course of 6.25 years? Did you have business or investment opportunities that would have returned more than 3.00%? If so, this further increases the timeline for how long you have to keep the mortgage to make the math of paying points work in your favor. And to make matters even more confusing, there can be tax issues surrounding the paying of points as well, which you should run by your tax professional.
In an effort to keep from leaving you totally up in the air and more confused than when I started, despite all the moving parts, I do have some general recommendations for determining whether or not to pay points. Based on the example above, if you know you are unlikely to keep your mortgage for more than 6 years, paying points probably does not make sense. If you think you will keep your mortgage for at least 10+ years, and you have the ability to pay more up front, paying points probably does make sense. And obviously, the longer you keep the loan, the better choice it was to pay points in the first place.
As with all things financial, each situation and scenario needs its own analysis based on your specific goals, resources, time-frame and overall financial strategy, but this is not a choice you should have to make all by yourself. A good lender, tax consultant or financial planner should be able to help you navigate the decision to pay or not to pay points on your next mortgage or refinance.
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