How Points Work on a Loan
A point is an optional fee you pay when getting a home loan. Sometimes called a discount point, this fee helps you secure a lower interest rate on your loan. If you would benefit from a lower interest rate, it might be worth making this type of up-front payment. However, it may take several years 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 1% of your loan. Your lender might say that you can get a lower rate by paying points, and you need to decide if the cost is worth it.
For example, assume you’re getting a loan for $100,000. One point is 1% of the loan value or $1,000. To calculate that amount, multiply 1% by $100,000. For that payment to make sense, you need to benefit by more than $1,000.
Points aren't always in round numbers, and your lender might offer several options. For example, you might be able to pay 1%, 0.50%, or any other number, depending on your lender's offerings. Compare those quotes among several other lenders to figure out which loan is best.
Benefits of Paying 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.
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 on your loan. Interest is the cost of using somebody else’s money, and it can add up to a substantial amount when you’re working with a home loan. These loans may be for large dollar amounts, and they last for many years (resulting in some hefty interest costs). A lower rate means you’ll pay less interest over the life of your loan.
The interest rate is part of your monthly payment calculation. In general, a lower rate means a lower monthly payment, making it easier to manage your monthly budget. Points are a one-time cost, but you benefit from lower monthly payments for many years to come.
You might get some tax benefits if you pay points, but that shouldn’t be the main factor in your decision. Depending on your situation, 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 a CPA before you decide on anything.
None of the benefits above come for free. You need to make a lump-sum payment for the cost of the point(s) when you get your mortgage. Paying points can cost thousands of dollars, and it’s not always easy to come up with that money in addition to a down payment.
Deciding to Pay Points
If you can afford to pay for 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.
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, a more practical approach for most people might be:
- Figure out how many points you can afford to pay.
- Find out how much those points would reduce your monthly payment.
- Consider how many months of reduced payments you could enjoy before you choose to sell.
- Evaluate how much you might save on interest over several time frames (five and ten years, for example).
- Decide whether it makes sense for you.
Some tips to help you evaluate:
- Calculate different scenarios for how your monthly payment changes with points.
- Build an amortization table to see how your interest costs change over time (you can use free spreadsheet templates to help).
- Use an online points calculator.
- Ask your lender for calculations.
A spreadsheet or amortization table is probably the best tool for getting a detailed view of how points affect your loan. Most people don’t keep a loan for the full 30 or 15 years—you might refinance your loan or sell your house before then, and an amortization table allows you to spread the benefit of the points over the exact number of years you keep your mortgage.
With a spreadsheet, you can customize things to get a realistic analysis of your interest costs and monthly payments.