When Should You Use Points to Reduce your Mortgage Payment?
Anyone who has done any research into taking out a mortgage has surely heard of points, but based on the feedback of our readers, few seem to actually understand how the points system works. In a nutshell, points refers to paying an upfront cash payment in exchange for a lower interest payment (and lower monthly payment, by extension). It is also possible to receive a rebate (negative points) in return for paying a higher interest rate.
Many lenders take advantage of (borrower misunderstanding of) points in order to make it look like their interest rates are lower than their competitors, when in fact the difference can be explained entirely by the points. On the surface, paying points would seem like a great option, since mortgage affordability is generally calculated backwards, using monthly payment – rather than the size of the mortgage – as a starting point.
In this way, the numbers can be manipulated, such as to make it so a potential borrower can afford a larger mortgage simply by extracting an upfront payment in exchange for a lower monthly payment. Of course, this can also be achieved by simply increasing the size of one’s down-payment, but yields slightly different savings. Generally speaking, a higher down-payment is more economical in the short term, while using points to buy down the rate is only beneficial over the long-term.
So, how can you go about calculating whether it makes sense to pay points? This Points Calculator makes this question easy. Simply plug in the loan amount, points, interest rate, interest rate with points, loan term, and a realistic return on investment, and the calculator will quickly generate a break-even point- the amount of time it will take before you can achieve positive savings on your mortgage.
In other words, the points system inherently favors the bank over the short-term. It’s impossible to achieve savings from Day 1. Instead, you must plan on living in your home (and keeping your current mortgage) for a certain number of years before paying points becomes worthwhile. If you have every reason to believe that you will stay in your home longer than the break-even period, then it makes sense to pay points. Instead, if you plan on refinancing or “trading up” before the break-even period, it probably makes more sense to simply increase the size of your down-payment.
Another consideration is whether to roll the points into your mortgage, in order to avoid making a large up-front payment. This will significantly extend the break-even period and is only economical if your savings rate (i.e. expected return on investment) is higher than your mortgage rates, and your marginal tax rate is low. The latter is a factor because financing your points allow the tax benefit to be amortized over the life of the mortgage, while an upfront payment can only be deducted in the year in which it is paid.
Finally, it’s possible to temporarily buy-down your mortgage payment, such that you pay a lower rate for only a few years. The 2/1 buy-down and 3/2/1 buy-down are the most common and straightforward, with the latter reducing your interest rate by 3% in the first year, 2% in the second, and only 1% in the third year, before reverting to the stated rate. Typically, you shouldn’t expect to achieve savings from a temporary buy-down; rather the perceived benefit is that you can delay the normal payment for a couple years, giving your income a chance to catch-up.