Explain mortgage points to me

[disneysteve]

When we got our mortgage and each time we refinanced, we did it with zero points. Now that I'm watching the rates and thinking about possibly doing another refi, I see that rates are lower if you pay points, but how does that work exactly? If I pay 1 point, I know that represents 1% of the loan amount, but what happens to that money? Assume it will be a $100,000 loan for simplicity (and also because that's pretty close to the actual number). And how are our taxes affected? I seem to think points are deductible somehow.

[maat55]

Points are prepaid interest. I assume, you can write them off on your taxes for the year they are paid in.

[jIM_Ohio]

One point is 1% of loan amount. It will probably lower rate of loan by .25% or .125% (check with bank). You can buy fractions of a point too.

We refinanced last June. We paid one point and then had money left over after our appraisal was higher (we were doing an 80-10-10 refiance). So the 80% was of a higher amount and become more like an 80-9-11 or 80-8-12. Because the loans had certain numbers on them already, the extra money bought a fraction of a point, which lowered rate from 5.875 to 5.75.

In your example, loan amount of 100k, a point would cost 1k. How much it lowers rate would be .25% (for example). You would then want to compare payment at base rate (say $1000/month) to lowered rate (say $920/month). In this example you would save $80/month and break even in 13 months (in 13 months the point paid for itself).

The $1000 paid in points is also deductable on income taxes (like mortgage interest).

[tripods68]

When we got our mortgage and each time we refinanced, we did it with zero points. Now that I'm watching the rates and thinking about possibly doing another refi, I see that rates are lower if you pay points, but how does that work exactly? If I pay 1 point, I know that represents 1% of the loan amount, but what happens to that money? Assume it will be a $100,000 loan for simplicity (and also because that's pretty close to the actual number). And how are our taxes affected? I seem to think points are deductible somehow.

Here's what I found on googling this topic:

Points are one type of fee paid at closing by you to your mortgage lender. There are two types of points: Origination Points and Discount Points. Each point equals 1% of your loan amount. For example, 1 point on a $100,000 loan would cost $1,000. That is the difference between Origination Points and Discount Points?

They differ in where they are applied. Origination points are charged to recover some costs of the loan origination process. Typically, your Loan Officer's compensation is based on the Origination point(s). Depending on the lending institution, the Origination Point(s) may be negotiable in whole or in part.

Discount Points are used to "buy" your interest rate lower. This is known as a rate "buydown." A general rule of thumb is that one full Discount Point will lower your fixed interest rate .250% or your adjustable rate .375%. These points lower the interest rate for the entire term of the loan. There is usually some flexibility by the lending institution in determining the actual buydown formula, but less than with Origination Point(s).

What about Points on Deductibility?

The tax code treats points paid in cash differently on purchase and refinance transactions.

On a purchase transaction, points paid in cash are fully deductible in the year the loan is closed. If the points are financed, they remain deductible in the first year if the cash contribution by the borrower for down payment and other costs exceeds the points. If the financed points exceed cash outlays, they are deductible as interest, not as points (see below).

On a refinance, points paid in cash are deductible but the deduction must be spread evenly over the term. If the points were $3600 and the term was 30 years, for example, the deduction is just $10 a month! However, if you pay off the loan early, all unused deductions can be taken in the year of payoff. If the loan cited above is paid off after 5 years, for example, a deduction of $3,000 could be taken in year 6. If the points are financed, they are not deductible as points.

If financed points are not deductible as points, they are deductible as interest. The loan amount will be higher, and therefore interest deductions will be greater, but these deductions are spread over the life of the loan. If the loan is repaid early, the unused deduction is lost.

[safari]

It rarely makes sense to pay points. Basically you're paying extra to get a lower rate, so to make it worth it you have to keep that mortgage for a while. Chances are that you will either sell your house or refinance it before it becomes worthwhile. You can use a calculator to figure out when your break even point will be. The opposite of paying points is refinancing without closing costs. In that scenario the bank is paying the closing costs for you in return for a higher rate. When the rates are going down, it makes a lot of sense to refinance at a higher rate, like 5.75%, but pay no closing costs. Then you can refinance again and again when the rates continue to drop further because you won't be incurring any out of pocket expenses every time you refinance your mortgage. On the other hand, when you pay points and closing costs, and then the interest drops another 1% in a year, you will regret it.

[MonkeyMama]

Agreed with tripod, the tax deduction is spread over the life of the loan, on a refi. (In a purchase you usually get to deduct the points up front).

If you get a 15-year refi loan then you can only deduct 1/15 of the point every year. (& then you have to remember for the next 15 years).

I am not sure I agree that it rarely makes sense to pay points. I guess it depends on a lot of factors.

We have never paid points either steve, I just thought they were to be avoided. I regret it now. Our last refi was to 5.75% - no points (2003). We could have locked in 5.5% rather easily and broke even within the year. (I think our breakeven was 6 months without a point). Anyway, since we knew we would likely never refi again and never move again, we would have been smart to get the 5.5. Now we are trying to refi to 5 or 5.25. It might work out for us I guess. But since I never expect to find a better rate and we are still so early in our loan, the points will really make sense this time. But basically rates never dropped much from our last refi and I never really expect them to. Sounds about the same for you. I think a point may make sense. I have heard in general it is not worth paying more than one point, and that I would probably agree.

I have heard a general rule if you breakeven in 3 years it is worth it. I am not sure I agree. Every loan is so different. What I would do is play with a loan amortization schedule to see how far you really come out ahead in the end. What if you pay your old payments, how quickly will you pay off the mortgage with the new rate? & then consider that you have to pay the closing costs on top of that. Then you can see where your true breakeven is. The points could put you behind and it wouldn't be worth it. But everyone's situation is so unique.

[jIM_Ohio]

It rarely makes sense to pay points. Basically you're paying extra to get a lower rate, so to make it worth it you have to keep that mortgage for a while. Chances are that you will either sell your house or refinance it before it becomes worthwhile. You can use a calculator to figure out when your break even point will be. The opposite of paying points is refinancing without closing costs. In that scenario the bank is paying the closing costs for you in return for a higher rate. When the rates are going down, it makes a lot of sense to refinance at a higher rate, like 5.75%, but pay no closing costs. Then you can refinance again and again when the rates continue to drop further because you won't be incurring any out of pocket expenses every time you refinance your mortgage. On the other hand, when you pay points and closing costs, and then the interest drops another 1% in a year, you will regret it.

I disagree. Monkey mama's follow up was much more accurate.

If I have a loan which I pay $1800/month on (P&I), then I can drop the payment to $1500 (P&I) for closing costs of 2k, or drop it to $1400 (P&I) and pay 4.5k, The $100/month savings pays for the 2.5k it cost to reduce the rate in 25 months. Every month after that is cash in my pocket.

Over a 360 month loan (30 years), 335*$100 is $33,500 without any interest tacked on. Not chump change at all.

Paying points makes sense if you keep the same house for an extended period of time. Borrowing money at lower rates will also reduce temptation to refinance again until rates drop significantly (the first rate drop did not even lower rates enough for my buy down to be considered a high rate).

Paying points may not make sense if you have an ARM, if you plan to move again, if your house decreased in value (this is a slightly different issue, though), or if you could invest the buy down money somewhere else and get a higher return.

Paying points does make sense if you need to improve cash flow within the budget.

[safari]

Before anyone considers paying points should read this article.

Do mortgage applicants seeking lower interest rates end up paying too much in upfront points? A new statistical analysis suggests that only a small fraction of consumers who opt to pay points hold onto their mortgages long enough to actually recoup the costs.

In fact, according to first-of-its-kind research by Penn State business professor Abdullah Yavas and Yan Chang, a senior economist at mortgage investor Freddie Mac, home buyers who paid points with their loans tended to pay off their loans 37.5 months before the "break even" point.

"The average mortgagor with points ended up defaulting, moving or refinancing more than three years before" they recouped the upfront cash outlays on those points, according to the authors. Yavas and Chang examined detailed data on 3,785 loans closed between 1996 and 2003 that were funded or securitized by Freddie Mac.

Of the borrowers who paid points to lower their rates, only 1.4 percent stayed in their mortgages long enough to financially justify the payments. Conversely, of the home buyers in the study who chose not to pay points, only 1.5 percent of them would have been better off by paying points to lower their rates.

[safari]

Does It Make Sense to Pay Points?

[disneysteve]

safari - What you've posted is true for the "average American" but as we've often concluded, many of us here at Saving Advice are far from average.

"Statistically, many folks don't hold mortgages for six years."

We always hear that the "average American" moves every 7 years, and that may be true, but some of us don't. We've been in our home since 1994 and plan to stay here until we retire in 20 years. We never bought into that whole "starter home" nonsense.

So the general advice that applies to that average person might not apply to me. If we refi with a 15-year loan, we will keep it until it is paid off. Assuming we get a rate under 5%, I think it is highly unlikely that we will be refinancing again in the future.

Thanks for all the replies. I guess I need to hit the mortgage calculators and run a few scenarios through to see which way works out the cheapest.

[DebbieL]

I agree with you Steve. I honestly don't know many people that move around so often once they've bought a place. My parents have been in their house 37 years, my sister and her husband bought in 1995 and have no plans on moving up (gag). My other sister and her husband were in their place for over 20 years until her death from cancer. Starter home? What's that? It seems like a manufactured term from the Realtors. Kind of like the diamond people convincing everyone they have to buy a diamond engagement ring. Whoever heard of that 100 years ago?

[safari]

I agree with you Steve. I honestly don't know many people that move around so often once they've bought a place. My parents have been in their house 37 years, my sister and her husband bought in 1995 and have no plans on moving up (gag). My other sister and her husband were in their place for over 20 years until her death from cancer. Starter home? What's that? It seems like a manufactured term from the Realtors. Kind of like the diamond people convincing everyone they have to buy a diamond engagement ring. Whoever heard of that 100 years ago?

Even if you know that you will be staying in that house for the next 20 years, it doesn't always mean that you should be paying points to lower your rate. If the rates continue going down, you might want to refinance again, so the points that you paid will be wasted money. In other words, you should only pay points if you're pretty sure that
1) You won't be selling the house in the next 7 years
2) You won't be refinancing your mortgage in the next 7 years because you think that the rates won't get any lower than they are now.

[jIM_Ohio]

Even if you know that you will be staying in that house for the next 20 years, it doesn't always mean that you should be paying points to lower your rate. If the rates continue going down, you might want to refinance again, so the points that you paid will be wasted money. In other words, you should only pay points if you're pretty sure that
1) You won't be selling the house in the next 7 years
2) You won't be refinancing your mortgage in the next 7 years because you think that the rates won't get any lower than they are now.

Most point pay for themselves within 18 months, more often sooner than that.

If the point cost $2000, and the loan saves a person $80 a month, the point is paid for in 2 years (25 months).

Even if rates lower in that 2 year period, the point you paid last year just make the rates have to get real low to even put the refinance card on the table.

In my case I paid close to 2.5k for a point on a mortgage in June of 06. It got me a 5.75% rate when rates were in the 6% range. Add to this the only reason for the refi was to get our second mortgage on a fixed rate product, and the point allowed me to lower the payment on the first to pay for the 2.5k within 18 months.

It appeared to be a good short term move- we've already saved around $300/month for 8 months on the lowered payment between first and second mortgages combined.

For rates to get lower than 5.75% will take some significant downward movement in rates (some people might be getting 5.5% now, but I doubt many can get that rate). So the buy down saved me some drama of "do I refinance now", or do I wait. I wait, because rates need to get lower to improve my situation.


Second, I do think people move often. Between the ages of 18 and 23, here are my moves:

fairport, NY
flint, MI
ann arbor MI
potomac MD
flint MI
dearborn MI
cincy, OH

that is 7 moves in 7 years. Put 40k miles on a car in one year in 1997- that flint to potomac to fairport commute 3-4-5X per year was a killer. If you add in that I lived in shippensburg PA, the Gaithersburg MD before moving to Potomac (each of those stops was around 2-6 weeks), that is 9 moves in 7 years.
Add to that a move in 2000 to Milford OH (bought a condo), and another move in 2005 to cincy OH (sold the condo) and another move in 2005 back to Milford (we needed to move to an apt while house was being built), that average gets skewed considerably based on early adulthood years. 12 moves in 20 years.

[Scanner]

I agree with the sentiments here.

I may refinance to exactly the same rate I have now (6%) but change it to a 15 year loan with 0 points.

Why?

Because if I pay points to get that 4.75-5% mortgage and I move, I'm screwed.

Not to mention closing costs. . .which are just the cost of doing business.

There's always a chance we may move.

To make the number guys more complicated. . .there's always the question of if you have a $100,000 loan and you have 2 points of money to spare (2K). . .why not just prepay your current mortgage by $2000?

That in of itself will lower the loan term.

It's complicated stuff for sure.

[safari]

Let's look at a specific example. I used E*Trade's website to check rates for a $200K refinance. They don't have the lowest rates, but this is not the point. If you're to get a 15-year fixed loan with 0 points, the interest rate will be 5.75% and monthly payment will be $1660.82. If you pay 1 point, the interest rate drops to 5.375% (0.375% lower) and the monthly payment will be $1620.94 ($39.88 lower). 1 point means you will be paying $2,000 up front. If you refinance at the higher rate without points, you can put that $2,000 in a CD at say 4.00%. You will be earning $80 a year (actually it will be more due to compound interest, but let's ignore it for simplicity sake). $80 a year translates to $6.67 a month. That means that you will be really saving $33.21 a month ($39.88 - $6.67) by paying a point up front. To break even you will need over 60 months ($2,000 / $33.21 = 60.22) or 5 years. In other words, you need to be sure that you will neither sell nor refinance your house again in the next 5 years just to break even. It may make sense for some people, but they have to run the numbers to make sure that they understand what it entails.