Discount Points (Points)
Points are quite a useful tool helping a borrower to lower the interest rate on his mortgage loan. The price of one point equals to 1% of the amount you borrow. If you pay this 1% amount in cash at the loan origination, the interest rate of your loan will drop by usually 0.25 percentage points. Each new discount point bought lowers the loan interest rate by another 0.25 percentage points. Thus, a 7% original rate can be reduced to 6.5% by buying 2 points. Sometimes the 0.25 percentage points off the rate become pricier if you go for more than 2 discount points. The lender may require that you buy, say, 3.5 discount points to reduce a 7% rate to 6.25%.
You cannot buy your interest rate totally out, though. Usually lenders offer several combinations of the rate and points for you to choose from. If you see a 7% and 2 points offer in an ad, it is not very likely to be the only option available. All you have to do is ask.
Even though the idea of discount points looks rather attractive, I find it important to draw your attention to a number of subtle matters involved, and help you avoid any financial losses that may occur if the points get to be applied inappropriately.
As I have mentioned before, points have to be paid for in cash. If you are low on cash at the time of the loan origination, do not buy points, first make sure you have enough cash for an at least 20% down payment. Avoiding PMI is a lot more important!
The calculator can help you estimate whether points can be any use for you at all. Even though they do reduce the rate, the price of this reduction is pretty high. The points are not cheap and you have to make sure they are worth the money. The key to this estimation is the break-even period - a period of time by the end of which the amount you have paid for the points and as monthly payments becomes equal to the amount you would have paid as monthly payments if you had not bought any points. This is the break-even point. Only after this moment the points will start to really save you some money. The length of the break-even period usually varies around 3-4 years, which brings us to the bottom line of the paragraph - buying points only makes sense if you are sure that you will keep this particular mortgage longer than that. Long-term Fixed Rate Mortgages potentially have the best return on points.
Points bought for a short term Fixed Rate Mortgage may yield some return, too, depending on how long you stick to it. Buying points for an Adjustable Rate Mortgage is usually a less wise choice. The rate you buy down will hold only during the initial period, i.e. until the first rate adjustment. The advantage that you do get, though, is that the lower initial rate determines a lower maximum rate, if the overall maximum rate cap of your Adjustable Rate Mortgage is a value relative to the initial rate, as opposed to an absolute one. And for that matter, there’s been a word around of lower point prices on short initial rate period Adjustable Rate Mortgages. The break-even rule holds for Adjustable Rate Mortgages, too, but it is harder to estimate, because of the changing indexes and rates.
The usually painful question of taxes proves to be quite significant and still painful in regard to points, the effect they have on the interest rate, and consequently, the amounts paid towards interest. Interest payments, as well as point payments, made in a given year are deductible in that year. On a purchase transaction, points are deductible in the year of purchase, but on a refinancing, points must be deducted over the life of the loan. There are other regulations about the deductibility of points that are explained on the IRS web-page. However, each case is unique and requires special attention, consideration and professional advice.
One general rule holds, though: the lower the interest rate > the smaller the amount of money paid as interest > the lower the amount you can deduct from taxes.
Now, the last, but not the least - negative points. This is the way points work the other way around: the lender pays some of the closing costs for you in exchange for a higher interest rate on your loan you have to accept. Negative points can become your (rather expensive though) way out of a situation, when you cannot afford paying all the mortgage closing costs yourself. It is, I’d say, quite a desperate and costly measure. I wouldn’t recommend resorting to it, unless it is really necessary. If you got yourself into a mortgage with negative points, try to get rid of it as soon as possible. Do not wait until the overcharged interest rate depletes your funds.
And always remember - you are not obliged to buy any points. They are just an option provided for your convenience if you want it that way. Nobody can make you buy any points if you don’t feel like doing so.
