How Points Work on a Loan

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A point is an optional fee you pay when you get 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 upfront payment. However, it may take several years to recoup the benefits of paying points.

Key Takeaways

  • Points are upfront payments that reduce the interest rate on a loan.
  • Paying points can help reduce your monthly payments and the total cost of the loan.
  • In general, the longer the length of the loan, the more likely it is that points will benefit the borrower.

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 whether the cost is worth it.

For example, suppose that 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

Tip

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 on your loan. Interest is the cost of using someone 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.

Monthly Payment

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.

Taxes

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 above benefits comes 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 whether 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:

  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 before you choose to sell.
  4. Evaluate how much you might save on interest over several time frames (five and ten years, for example).
  5. Decide whether it makes sense for you.

Some tips to help you evaluate:

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.

Frequently Asked Questions (FAQs)

How do you calculate points on a loan?

One mortgage point is equal to 1% of your loan amount. So, one point on a $200,000 loan would cost $2,000 up front. One point will usually drop your interest rate by 0.25%, so you can compare the total costs of your loan by looking at interest and upfront costs.

What are negative discount points on a loan?

Negative points work in the opposite direction from positive points. If you want to borrow a point, for instance, you would take a 0.25% increase in your interest rate in exchange for a 1% credit toward upfront costs.

How do you avoid points on a home loan?

Your lender should clearly explain any options you have for buying points, compared to funding your loan without points. To avoid points, simply tell your lender that you want to pay for a loan with no points.