Mortgage points are upfront interest a buyer pays at closing. One point equals 1% of the original loan balance. If you choose to pay two points on an $800,000 mortgage, that is $16,000, which is either due at closing or can be rolled up on your mortgage.
It seems counterintuitive that a buyer would consciously choose to pay extra costs, but you need to weigh certain factors in order to determine if this is financially beneficial to you.
Why pay points?
You may not be in the mood to fork over additional monies, the reasoning you have paid enough for a New York City apartment, particularly when you factor in closing costs. There are legitimate, financially sound reasons when it makes sense, however.
Mortgage points, which is also referred to as discount points, amounts to paying immediate interest to the lender. In exchange for the lender having access to the funds, you receive a lower interest rate.
Therefore, you need to consider the time you plan to spend in your new home, along with the interest rate you will pay with and without points. The longer your time frame, the more attractive it is to pay points.
Once you have these key pieces of information, you can calculate how long it will take to recover the points paid. This is referred to as your break-even point, and it is the crux of the decision whether or not to pay points. After this period of time, you will have made money – essentially it is money in your pocket.
It is a simple calculation. Merely compare the interest rate on your mortgage with no points to one with points. Then, divide the cost paid for the points by the monthly savings achieved due to the lower interest rate. This is your break-even period of months.
You can pay a range of points, starting with zero. But, it is easy to do the calculation for each scenario.
Applying the concept
A numerical example will clarify the concept. Let’s say a lender offers a 30 year fixed mortgage at 4% with no points. However, you can lower your borrowing rate by 0.25% to 3.75% if you are willing to pay one point.
Assuming you are taking out a $600,000 mortgage, your monthly payment (principal and interest) under the 4% loan is $2,864.49. If you decide to pay the point, your monthly payment under the 3.75% rate is $2,778.69.
This means your monthly savings under the one point/3.75% rate is $85.80. However, you have made an upfront payment of $6,000 (1% of $600,000). Therefore, your break-even period is 70 months.
Based on this calculation, if you plan on staying for longer than this, you should consider paying the point and taking the lower rate.
The points you pay may be tax deductible as mortgage interest, providing you itemize your deductions and your mortgage is not greater than $1 million. This should be watched closely since Congress is currently debating tax legislation that could lower the deduction to interest on a loan up to $500,000.
While running the numbers gives you a basis, remember to consider your financial position, particularly your cash balance. For instance, you may want a 20% down payment to avoid taking out private mortgage insurance (PMI). Also, co-ops may have rules on the amount of liquidity you must have after closing, which could be one to three years of maintenance and mortgage payments.