Points or No Points: Which Is Right for You?

When you’re getting a mortgage, one of the questions that often comes up is whether you should pay points to get a lower interest rate—or take a higher rate and pay no points.

The answer depends on your situation, your plans for the property, and how long you expect to keep the loan.

Watch here: Is Paying Points Worth It? The Numbers Don’t Lie (4.22)

Points are also commonly called discount points or, depending on the context, origination fees. In this discussion, we’re talking about money paid upfront as part of your closing costs to permanently buy down your interest rate.

One point equals 1% of the loan amount. For example, on a $700,000 loan, one point would cost $7,000.

You pay that money upfront on a purchase as part of your closing costs. On a refinance, the cost can generally be included in the new loan.

The idea is simple: pay more upfront in exchange for a lower interest rate and, therefore, a lower monthly principal and interest payment.

Let’s look at a simplified example using a $700,000, 30-year fixed-rate loan.

With zero points, the example uses a 6% interest rate, giving us a monthly payment of $4,196.85. If you pay one point, or $7,000, the rate could be reduced by a portion of a percentage point. In this example, one point lowers the rate by 0.375%, bringing it to 5.625%, and a monthly payment of $4,029.59.

That lower rate results in a lower monthly principal and interest payment.

This does not take into account the fact that at 6% there is less principal in the monthly payment than at the lower rate, which should also be considered. The principal amount in the 6% interest rate is $696.85 on payment #1 and grows more and more each month. The principal on the 5.625% interest rate is $748.34 and grows every month from there. That’s an extra $51.49 per month!

The important question isn’t simply, “How much will I save each month?”

The better question is: “How long will it take for those monthly savings to recover what I paid upfront?” — in other words, the return OF your investment.

This is where the break-even calculation becomes important.

If you pay $7,000 upfront and save approximately $167 per month, you divide the $7,000 upfront cost by the monthly savings of $167.

That gives you a break-even period of approximately 42 months, or about three and a half years.

If you add the principal reduction of $51.49 on top of the net savings of $167 = $218.49

$7,000 / 218.49 = 32 month breakeven. Something to think about!

In other words, you would need to keep the loan for roughly three and a half years for the monthly savings to recover the $7,000 you paid for the point. After that point, the additional monthly savings become a pure benefit or profit.

This is where your plans matter.

If you think you may sell the home, refinance, or otherwise pay off the mortgage before reaching the break-even point, paying points may not make financial sense.

For example, if you pay $7,000 upfront and refinance after two years because interest rates have fallen, you may not have had enough time to recover that initial $7,000 through your monthly savings.

On the other hand, if you expect to keep the mortgage well beyond the break-even point, paying points could make more sense.

There is also uncertainty about where interest rates will be in the future. If rates fall enough to make refinancing attractive, the benefit of having paid points on the original loan may be reduced.

There isn’t one answer that works for everyone.

The decision should take into account the cost of the points, the monthly savings, the break-even period, your plans for the property, and how long you expect to keep the mortgage.

In general, I recommend considering zero points because of the possibility that a homeowner may have an opportunity to refinance before recovering the upfront cost of the points.

The key is to understand the math before making the decision. A lower interest rate isn’t automatically the better deal if you have to pay a significant amount upfront to get it.