When you look at price quotes on mortgages, you should always note both the rate and the points. A discount point is one percent of your loan. So paying 1 point on a $200,000 mortgage costs $2,000. Usually this is paid upfront as part of your closing costs, but some people also finance their points (roll it into an existing or new loan). The more discount points you pay, the lower the interest rate on your mortgage.
For example, here are some quotes that I pulled up today for a $400,000, 30-year fixed-rate loan:
| Loan | Rate | Points |
| #1 | 5.000% | 3.326 |
| #2 | 5.500% | 0.965 |
| #3 | 5.625% | 0.461 |
| #4 | 5.750% | 0.000 |
So you have to ask whether you would you rather pay
- a higher amount upfront + lower monthly payments?
- or a lower amount upfront + higher monthly payments?
The general logic is pretty simple. Let’s say your local gas station asked you to pick between these two scenarios for buying gas:
- $100 upfront + $2 per gallon.
- Nothing upfront + $3 per gallon.
You could probably do the math pretty quickly to see how many gallons you’d have to buy to break even. After that point, you’d be happily buying cheap gas and saving more money each subsequent fill-up. But if you don’t use much gas or might move away from the gas station soon, you may never reach that point and never make back your upfront outlay.
In reality, there are additional complications like “what would my unused money be earning?” and “what about tax-deductions?”, so the easiest way to do this calculation with mortgage rates/points combos is to use an online calculator like this one at the Mortgage Professor.
Let’s use it to compare Loan #1 and Loan #4 above. I put in the following info:
…and receive these results:
Taking Points or Not: Will You Keep Your Mortgage 4-6 Years?
So if you keep the loan less than 4.83 years, you won’t quite make up your upfront points paid. But after 4.83 years, each monthly payment you make will mean you saved more money over the higher rate loan. ($10,000 after 10 total years in this case.)
So the question is – how long will you stay in your home? The weird thing is, almost all loan rate/point combos that I’ve seen give you a break-even period of about 4-6 years. Even if you take as little as 0.50 points. So that’s the magic number. More or less than about 5 years?
I’ve read stats that say the average mortgage lasts about 7 years. But you should know yourself better than some average. Is this a starter home? How stable is your job? Are you rooted to the area due to family or other reasons? If you think you’ll stay less than 5 years, don’t pay points.
How Many Points? Well, How Confident Is Your Guess?
Now let’s compare Loan #1 and Loan #2, only have a difference of about half a point. The breakeven period is now 4 years, with only a $2,187 advantage over 10-years. So here both the risk and potential reward is less. If you’re wrong and you move earlier than 4 years, you might be out a thousand dollars or so. But even after 10 years, your advantage would only be about $2,000.
So, the more points you pay, the bigger the bet you make that you’ll stay past the break-even period. You could pay 4+ points or more if you really wanted to.
Update: As commenter Ted has pointed out, paying points also reduces your ability to refinance to a lower rate mortgage before that break-even period. So room for rate drops should also be put into consideration.
As for us, we definitely felt that we were going to stay longer than 5 years, but didn’t want to “bet” that many points. So we ended up paying 1 discount point to lower the rate on our loan to 5.625% at the time. I really don’t expect for rates to drop far enough lower so that a refinance would be worth it, but I could be wrong.
Finally, you should always compare different rate quote combos from different lenders. One lender might not have the best zero-point loan, but might have a relatively awesome 2-point loan. Don’t be afraid to ask for additional rate/point combinations if you don’t get them at first.
The post is a new addition to my Experiences in Buying A Home.
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Since the rate on the loan is higher then your savings rate, why not put the money “into” the house. if you did this. I bet that the break even point would be much closer to 7.
Great write up here, but I think you should think about taking it the next step. That is now that you’re “ok” with paying points, what would be the effect of taking the higher rate, not paying points, but rather paying down the mortgage principal with that one time payment really early in the loan cycle. Not to mention that there could be more complex issues for those that have less than 20% down and face other costs like PMI and so on.
Its not just if you’re going to stay in the home. Its how long are you going to keep that mortgage. Rates could drop then you have to decide if you’re going to refinance the mortgage you just paid points on.
Nice write up. A couple of questions: Aren’t there other fees to consider? Do the APR rates shown by lenders already do the relevant analysis where all you have to do is think about how long you’re likely to be in the house (or refinance)?
One more comment:
I’ve always wanted to see someone unlock the mystery of how much the points cost. How do banks decide how many points is worth a 25 basis points on a mortgage? There has to be a formula or chart. If someone could determine a standard, then buyer could quickly analyze if the points offered were expensive or cheap.
1 pt ~= 0.25%
I had an interesting experience with a “point”. About 5 years ago, I was looking into refinancing my home (and took out some cash too) and waited and waited until the rate dropped to 5% (for a 20 year loan). Well I ran to the bank and locked the rate, which cost me a point at the time, which was $1,800.00. But I believed it was truly worth it — anyway, by the time we finally closed on the re-finance (which you’d think would more swiftly – but it didn’t), the rate had dropped again to an all time low (the day of the closing only) to 4.625. Well, of course, I let go of the locked rate – but you don’t get your money back.
Anyway, I was extremely lucky to get that rate — but still, I felt pretty stupid for running to part with $1,800.00, which turned out to be completely unnecessary.
PV of the future 2187 = approximately $1300.
This is all it really saves you.
Ted – Yes that is true. Paying points upfront means it is harder for you to refinance later on if rates drop and still make money. It’s tough to see rates dropping that much more right now, but who knows. Definitely would be a consideration if rates were higher.
Another reason it might not pay to take too many points, I suppose.
Mimi – Don’t worry, I ran in to lock in my rate with the mortgage broker at 8pm at night to lock for that day. It can be tough to pay thousands to save 0.5 point and then the rates drop by that much alone in a day.
This is one of your better posts. Simple statements like
“The weird thing is, almost all loan rate/point combos that I’ve seen give you a break-even period of about 4-6 years. Even if you take as little as 0.50 points. So that’s the magic number. More or less than about 5 years?”
….make reading this blog worthwhile….
I would echo Ted. I had a 6.75% 30yr jumbo which I thought was quite good at the time, but elected to take no points just to be on the safe side. Then sure enough, rates dropped and I was able to refi all the way down to 5.75%. Taking a point or some points up front takes away the option of moving your rate lower (especially when you haver to factor in closing costs of refi’s). The longer you stay in your house, the more likely it is that a lower rate, that is advantageous, will show up. I am convinced that lenders know that a point is worth not just the upfront cash, but also it slightly decreases their exposure to early payoff (i.e., your decision to ‘call’ your bond by paying it off early – usually via a refi, or perhaps by selling the property).
When you pay points you give the lender higher security of the income stream, and this allows them to lower their rate by dropping their risk premium built into the mortgage. In general, the banks statistical models are developed so that they win and you lose. Even if you win, many more will lose the gamble (kind of like Vegas odds). This is part of why I would never pay points.
enonymous – I would also consider that it’s all part of a continuum of options, as you can also get negative points (cash back) if you are willing to pay a higher interest rate than the zero-point rate. So would you pay the most negative points possible?
If you are going to purchase a home you might want to consider having the seller pay the points. With 10% down most lenders will allow the seller to credit up to 6% of the sale price toward the non-recurring closing costs. Points are a non-recurring closing cost. And here is the icing on the cake, even though the seller pays the points, the BUYER gets the tax deduction for the points paid! This is a strategy most real estate agents do not know about, but the financial impact for the buyer is huge!
Great post, lots of helpful tips. I hope this becomes a “popular post.”
This is a very interesting breakdown of looking at the break even point as a function of how long you plan to be in the house.
The overall cost is actually figured for you in the form of the APR. The APY is the actual mathematical rate you pay on your loan. The APR is the imputed rate based upon the reported costs (including any points). So you can compare apples to apples as to which loan is cheaper. As you point out, this calculation only applies over the full term of the mortgage (so 15 years for a 15 year mortgage.)
Incidentally, the reason all the loans break even at 4-6 years is the same gamble from the other side. Would you prefer an investment with an upfront 1% return (from the buyer’s point) and a 4% annual return or 0% return up front and a 5% annual return. After 5-ish years an investment becomes “long term” money instead of “short term” money. You don’t make “bets” as you call them with long term money because investors expect long term investments to be more stable.
Jonathan wrote, “I would also consider that it’s all part of a continuum of options, as you can also get negative points (cash back) if you are willing to pay a higher interest rate than the zero-point rate. So would you pay the most negative points possible?”
Lenders know borrowers shop among different lenders on rates. The zero-point quote is most heavily shopped. Therefore they try to make that one competitive. Once they get you in the door, they can try to sell you the idea of paying points or getting credit for closing cost. The other price points in the continuum of options don’t have to be as competitive. Therefore most borrowers are better off with a zero-point loan.
TFB – That makes sense, but is there any data that supports the idea that 0 points are most competitive? I’ve seen many places just advertise on rate, period, only to reveal the points later.
The reason I thought about this is because the wholesale mortgages rates listed at MtgProfessor.com says “Rates are interpolated between the rate just above and the rate just below zero points.”
I think the best option is to take 0 points since it gives you the most flexibility in the future from a refinance standpoint. My initial mortgage in 2002 was a 30 year fixed at 6.25%. In the summer of 2003 mortgage rates dropped and I was able to refinance at a 5.25% 30 year fixed rate. Since I had no points my break even was about 12 months to cover the closing costs.
Interestingly enough my mortgage banker always told me to go for 0 points.
Also since the stimulus package has increeased the conforming loan amount, people with jumbo mortgages could benefit from a refinance at a conforming rate.
I enjoyed reading this article and I think you have some great points. I would add that it’s tough to pay points in an environment where interest rates are falling.