Let’s say you’re about to buy a house. You’re at a family barbecue on the weekend. The sun is out, the kids are running around, there’s burgers on the grill. Your older brother comes up to you and asks if you found a lender yet. You tell him you got some quotes, and they’re all with zero points. Your brother puts his arm around you and says, “Make sure you get some quotes with points.” Your dad overhears him. He shakes his head and says, “I never had to pay points.” As if points are a fine for bad behavior, like points on your driver’s license when you run a red light.
Points aren’t like that. With most conventional loans, you have the option to pay points or not. But first, let’s talk about what a point actually is. A point is simply one percent of your loan amount. So if you’re borrowing $300,000, a point is $3,000. If you’re borrowing $250,000, a point is $2,500. Two points are just two percent of your loan amount. With the $300,000 loan, two points would cost you $6,000.
What Are Points For?
Discount Points are the cost of getting a lower rate. Let’s go back to your quotes from various lenders. They’re all with zero points. You follow your brother’s advice and ask what the rate would be if you paid a point. Now you’ve got a bunch of quotes with points. What do you do next? How do you know if you should pay points or not?
Break Even Calculation
Here’s what you do — you calculate what’s called a “break even” or how long it would take you to recover the cost of the points based on what you would save with the lower rate. Here’s an example: let’s say the best rate you’ve found so far for a thirty year fixed is at 3.75% with zero points. You ask about the rate with one point and your lender tells you it would be 3.50%. Based on your loan amount of $300,000, you would save $42 a month with the lower rate. But the point up front at closing costs you $3,000. Is it worth it to pay the point? Here’s where you calculate a break even. Take the cost of the point ($3,000) and divide it by your monthly savings ($42). You get 71.4. That’s the number of months it would take to recover the cost of the point – almost six years.
Six years?! That’s a long time!
But now factor in this important piece of information: points are tax deductible when you are buying a primary residence. So instead of costing you $3,000, the point could cost you $1,950 (depending on your tax bracket) because you can write off the cost of that point on your tax returns. So now your break even point is $1,950 divided by $42 or 46 months (less than four years).
So now is it worth it to pay points? It is if you plan on staying in the house four years or longer.
|Amortization Period||360 months (30 years)|
|0 Point(s)||1 Point(s)|
|Cost of Points (A)||$0||$3,000|
|Reduction in Monthly Payment (B)||$0||$42|
|Break Even (A ÷ B)||N/A||71.4 months (~ 6 years)|
|Cost of Points after Tax Deduction (C)||$0||$1,950|
|Break Even after Tax Deduction (C ÷ B)||N/A||46.4 months (< 4 years)|
What if you don’t have time to calculate a break even? Is there a quick and easy rule to fall back on to determine if you should pay points of not? Yes, there is. By and large, if a point reduces the rate by ¼% or more, it probably makes sense to pay a point. Conversely, if a point reduces the rate by less than ¼% (0.25%), it’s probably not worth paying points.
What if You Don’t Have Enough Cash to Pay Points?
What if you calculate the break even and based on how long you plan on staying in the house, it definitely makes sense to pay points, but you just don’t have the cash for any extra closing costs? Is there ever a situation where the borrower isn’t the one paying the points?
Sure — if you work out a seller’s concession where the seller pays a portion of your closing costs. With a seller’s concession, the seller agrees to pay a certain percentage of the sales price towards your closing costs. These types of concessions have to be worked out during the bidding process and written into your sales contract.
Another way to pay points if you don’t have the cash is to get a gift from a family member for some or all of your closing costs.
Finally, if you’re being relocated by your firm, they will often include reimbursement for some or all of your closing costs as part of the relo package.
I always try to explain what points are to borrowers and when it makes sense to pay them. Once, I was on the phone with a woman who worked in the fashion industry. I quoted her the rate with zero points and the rate with one point. I was about to go into the whole break even calculation but before I could, she asked, “How long does it take to burn off those points?” In her mind, a point was like the brownie she shouldn’t have had. With enough cardio, she could still fit into her skinny jeans. I worked out the calculation for her, confident she understood the concept.
So next time you get a quote from a lender, ask about paying points. You might be surprised at how much money you can save.