Should you pay the Points?

When researching mortgage rates, you'll find that the interest rate on a mortgage loan is always quoted with the “points” on the loan. Points are the major closing cost in obtaining any mortgage, but they can be traded off for a lower interest rate. Should you pay the points? It depends on your situation. To make the right decision, you need to know how points work.

What is a point? : Discount points & origination points

Points are upfront fees for borrowing money, paid at the time of the closing of the home. Points are actually percentages: A point is equal to 1 percent of the loan amount. For example, one point on a loan of $200,000 is $2,000.

There are two different kinds of points you can pay:

Origination points: These are fees charged by the lender either to cover the costs of the loan origination processor to boost profits. Depending on the lending institution, the origination points may be negotiable. Origination points are lender’s service fees, not prepaid interest, so they are neither traded off for a lower interest rate nor tax-deductible: they serve no real purpose for borrowers.
Discount points: These are interest that you prepay to "buy" your interest rate lower. Paying point(s) to lower the loan interest rate is also called as a "buy-down." It increases the closing costs while lowering the monthly mortgage payment. Paying discount points is in essence a trade off between paying money now versus paying money later. The more points you pay, the lower the interest rate on the loan. Discount points are considered a payment of interest, not a service fee, thus tax-deductible.

How to compare loan packages with different points

While you are out shopping for mortgages, you’ll probably notice that lenders offer various combinations of interest rates and points. There is no correspondent trade off between points and rates, but generally each point will lower your interest rate between 1/8 to 1/4%.

To perform an apples-to-apples comparison of mortgages from different lenders, get interest rate quotes at the same point level for each mortgage. If you are paying same points for the same rate, there is an advantage of paying discount points over origination points because discount points are generally tax-deductible.

A good way of shopping for mortgages is to compare loan offerings on the basis of actual cost. The lender’s disclosure of the true cost of the loan should indicate the annual percentage rate (APR) or the effective interest rate. The APR is designed to measure the "true cost of a loan." It creates a level playing field for lenders. It prevents lenders from advertising a low rate and hiding fees.

Note: Use the APR as a starting point to compare loans. However, You also need to know some downsides of comparing APRs. APRs are calculated assuming you keep the loan until it is paid off. If you plan to move out in just a few years, comparing just APRs would be meaningless. Besides, the rules to compute APR are not clearly defined: different lenders calculate APRs differently. It is wise to get a good-faith estimate from each lender to compare costs.

Should you pay the Points?

You can lower your interest rate by paying discount points. The more points you pay, the lower your interest rate. It's good to pay them or not? The answer could be both “yes” and “no”. How many points you want to pay, or whether you want to pay any at all, depends upon a number of factors including:

Your financial situation: If you are short of cash, you may have to look for loans with no or few discount points even if these loans will probably carry higher interest rates. If you are having trouble qualifying for the loan, you may wish to pay more points for a lower interest rate.
Number of years you remain in the home: It is suggested to pay points up front if you plan on keeping the loan for at least four years to ensure that you recoup the costs through lower monthly payments. To be more accurate, do some of the math yourself. Calculate how long it will take to earn back the points you paid up-front, via lower monthly payment. If you’re going to be in the house longer than that, you might be better off paying the points.
Your investment strategy: Instead of paying points, you could invest the money elsewhere over the life of the mortgage. If you think, in the long run, you can earn a higher return by investing the money saved on the points, you may be better off with a no point loan.