How Points Work on a Loan
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 at least 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 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 1 percent of the loan value or $1,000. To calculate that amount, multiply 1 percent by $100,000. For points to make sense, you need to benefit by more than $1,000.
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.
Total cost: When you borrow money to buy a home, you end up paying more than just the purchase price and closing costs, because 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, which 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 your 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 main driver for your decision. 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 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 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.
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:
- 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’d save on interest over several time frames (five and 10 years, for example).
- Decide whether to move forward.
Some tips to help you evaluate include:
- 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 also use free spreadsheet templates to help).
- Use an online points calculator.
- Ask your lender for calculations.
A spreadsheet or amortization table is really your best option for putting together a 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, and an amortization table allows you to spread the benefit of the points over the exact number of years you keep your mortgage, so you can view a realistic payment estimate.