Discount Points

Should You Pay Points?

Illustrative image of man in dollar shaped house representing home loan
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A point is an optional fee you pay when you get a loan (usually a home loan). Sometimes called a discount point, this fee helps you get a lower interest rate on your loan. If you would benefit from a lower interest rate, it might be worth making this up-front payment. However, it usually takes time (several years at least) to recoup the benefits of paying points.

How Points Work

Points are calculated as a percentage of your total loan amount, and one point is one percent of your loan.

Your lender says that you’ll get a lower rate if you pay one point (although sometimes you’ll pay multiple points). You need to decide if the cost is worth it.

For example, assume you’re getting  a loan for $100,000. One point is one percent of the loan value or $1,000. To calculate that amount, multiply 1% by $100,000 (see how to convert percentages for calculations). For points to make sense, you need to benefit by more than $1,000.

Why Pay Points?

Points help you secure a lower interest rate on your loan, and the interest rate is an important part of your loan for several reasons.

Total cost: when you borrow money to buy a home, you end up paying more than just the purchase price and closing costs – you also pay interest. Interest is the cost of using somebody else’s money, and it can add up to extremely large amounts when you’re working with a home loan (or any loan that features a large dollar amount and many years of borrowing).

A lower rate means you’ll pay less interest over the life of your loan.

Monthly payment: the interest rate is part of your monthly payment calculation. In general, a lower rate means a lower monthly payment, which improves your cash flow situation (and you monthly budget). Points are a one-time cost, but you’ll enjoy lower monthly payments for many years to come.

Taxes: you might get some tax benefits if you pay points (but that shouldn’t be the only thing you look at). Depending on your transaction, you may get those benefits in the year you pay points, or over a number of years. Check the IRS rules in Topic 504 – Home Mortgage Points, and speak with your local tax preparer before you decide anything.

Of course, none of the benefits above come for free – you need to make a lump-sum payment when you get your mortgage. Paying points can cost thousands of dollars, and it’s not always easy to come up with that money.

Should You Pay Points?

If you can afford to pay the points, you’ll need to figure out if it’s worth it. Here’s a general rule of thumb: the longer you’ll keep the loan, the more attractive points become.

You need to consider the overall economic value. If you’re the type of person who likes spreadsheets, you can determine the optimal choice by looking at future values versus present values. However, most people start with the following route:

  1. Figure out how many points you can afford to pay
  2. Find out how much those points would reduce your monthly payment
  3. Consider how many months of reduced payments you could enjoy
  4. Evaluate how much you’d save on interest over several timeframes (five and ten years, for example)
  5. Decide whether to move forward

Some tips to help you evaluate include:

A spreadsheet or amortization table is really your best option for getting realistic idea of how points will affect your loan because most people don’t keep a loan for the full 30 or 15 years – in most cases you’ll refinance your loan or sell your house before then.

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