With mortgage rates expected to rise over the upcoming months, home buyers will be hearing more about “points” when applying for a loan. Points are also likely to appear alongside of eye-catching interest rate advertisements.
Points are essentially pre-paid interest. A “point” is equal to 1% of the amount borrowed. On a $200,000 mortgage, one point would cost $2,000. Points may also be expressed in fractional amounts. In the example above, points of 0.500 and 0.250 would equal $1,000 and $500, respectively.
It’s important to understand that points are optional; you are not required to pay them when taking out a mortgage. However, lenders might advertise their lowest rates with a point attached. If you decline to pay the point, you would receive a slightly higher interest rate.
Whether it’s worth paying points to obtain a lower rate depends on your personal financial situation, and how long you intend to remain in the home.
Here’s an example of the math according to Bankrate.com. Please note that the actual difference you’d see in your mortgage payment depends on the market conditions at the time, and the rate offers you receive.
Let’s start with a 30-year fixed-rate mortgage of $165,000. The lender offers you 6% interest with no points. The monthly principal and interest payment would be $989.
Next, the lender offers you a rate of 5.5% if you pay 2 points. The points would cost you $3,300. ($165,000.00 x 2% = $3,300.) This gives you a monthly principal and interest payment of $937.00.
In the above scenario, if you opted to pay the 2 points, you’d be paying $3,300 to reduce your mortgage payment by $52 a month. Next, let’s calculate how many months it would take to recoup your $3,300.
$3,300 divided by $52 = 63 months. In other words, you’d recoup your investment in points in under 5 and ½ years. If you are staying in your home for at least 6 years, you’d be financially ahead by paying points. The longer you stay in the home, the greater the financial benefit of buying down the interest rate with points.
One more consideration: because points are pre-paid interest, they are currently an allowed deduction from itemized income tax returns. Paying points at closing could boost your first-year tax return as a homeowner, if you itemize, and your deductions exceed your standard exemption. See IRS.gov for more details, and speak with a professional tax preparer about your tax situation.
Remember, points are optional! Good advice is essential during the home buying and financing process. Your Exclusive Buyer Agent can refer you to local, trustworthy lenders who will explain all of your mortgage options. Find an EBA in your area today!