First things first. Make sure you understand what points are. Points (or discount points) are simply pre-paid interest. One point amounts to 1% of the total mortgage. If you have a $100,000 mortgage, one point costs $1,000. That’s pretty much all there is to it.

Now, why would anyone pre-pay interest? Good question!

You pre-pay interest to get a lower interest rate for the life of your loan. And because points are pre-paid interest, you can, in most cases, deduct them from your taxes in the year that you pay the points. That’s a nice one-time tax benefit!

So, if you want the lowest interest rate possible on any given day, you’d have to buy points, which is also called “buying down your rate.” Every day, when rates are issued, a certain amount of points are tied to certain interest rates. For example, if you’ve heard the term “zero point rate,” that means that rate has no points attached to it. You get that rate without pre-paying any interest. A one point rate would have one point attached to it and a two point rate, two points attached to it, etc.

If you want a rate below the zero point rate, you have to pay points to your lender. If you are willing to accept a rate above the zero point rate, you can actually get money back or a credit on your closing costs. This is often how “no closing cost” options are created – you typically get a loan with the highest interest rate available and a lender will credit back all your normal closing costs.

To find out if buying points will pay off for your situation, here’s some simple math you can do (go ahead, whip out the calculator):

OK, let’s assume you are considering two options on the day you want to lock your mortgage interest rate:

- a 5.25% mortgage interest rate that costs you one point.
- a 6% mortgage interest rate that costs you zero points.

In this scenario, you would lower your rate to 5.25% by buying one point upfront. This costs you $1,000 (1% of $100,000).

Now that you have your basic numbers, it’s time for some basic math. To figure out if buying points makes sense, divide the cost of points paid ($1,000 in the example above) by the difference in monthly payment between the two rates. In the example above, the difference in payment is $47.35 ($599.55 – $552.20). If you divide $1,000 by 47.35, you’ll get 21.12. This is the number of months it’ll take you to break even.

To summarize, it would take you just under 22 months to recoup your pre-paid interest money and from then on you would enjoy your low 5.25% for the duration of your remaining mortgage. If you think you will be in your home longer than your break even point, you’re saving money from that point forward. Now that’s a good investment!

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Hi I have a question and trying to decide. Purchasing a home for 665 k putting money down so loan amount would be 300 K . The property will be my second home. The rate quoted is 3.875 no points or 3.75 paying like .93 just under 1? Trying to decide if it would be beneficial to do this or just take the slightly higher rate. It’s not a huge payment difference. However it is a higher loan amount.Then your above scenario

Hi L:

So typically points are sold in eighths across the industry and 7/8 would be .875 points, but let’s assume for the moment you’re paying .93 points. The key is to figure out the payment difference and when you would break even in order to see whether it would be worth it for you. Under this scenario, you would pay $2,790 in points. Our amortization calculator doesn’t give exact numbers because fees vary by state. However, I can give you estimates. Since you didn’t specify a term, I’m using 30 years.

First, you would pay off your initial point investment in just under 11 years. You save $21.36 on the monthly payment. On that pace, you pay off the points in 130 months which is how I get there (2790/21.36). By making the point payment, you do save over $7,000 in interest. Of course, if your term is different, it’s going to change the numbers. I encourage you to play with the calculator. I hope this helps!

Thanks,

Kevin Graham

Doing the math on all kinds of scenarios is helpful. One other factor might be that when you pay down points and get a lower rate, you are also putting more money toward your Principle during those first years…so if you should sell in lets say 5 years, you will have paid more toward Principle and will therefore owe the bank less money… which means the investment in points (and that’s how you can view it) will earn not only the amount of savings per month on your payment, but also the amount less you will owe on the house, as well as the potential increased value of the home when you do sell…. If you are looking to diversify all of your assets, another good thing to do, consider this type of ‘investment’ as a further type of diversification… You may be able to earn more off that money if invested, but you may not… it depends on what the market does…and if you already have an amount in the market you are comfortable with and don’t want to assume more risk along those lines, it is reasonable to consider other ways to make money off that money. However, if you have no money in the market, I would say use that money to diversify yourself by putting it into the market rather than taking a larger position in your house… I could be wrong on all this, but it’s just the way I tend to look at things…from as broad of perspective as I can, i.e., from the standpoint of all of your money and how it is working for you across the board.

I agree, John! Everyone’s situation is different, so there is no one-size-fits-all scenario. Thanks for sharing!

Its smarter to do a refi (aka refinance), all you have to do is..

Get the loan with the original interest rate (which of course, is higher)..

Apply that same amount of money (that would be applied to buy down pts) to the principle balance (which could put at a lower interst rate with that same lender anyway) and REFI the loan ASAP for even more savings. Most folks usually REFI in the first few yrs regardless. (ding dong sound)

Buy down money DOES NOT go to the principle balance, it goes directly to the lender.

Why throw away more money to them? lol…

In short, the Buy-Down Point system is a little magic trick that lenders advertise to trick folks out of even more money upfront… don’t be fooled like most misinformed folks; just refinance (like many folks do anyway) when rates get better or when you pay down principle balance more. Cheers.

Hi Joshua:

I don’t disagree with you about paying down principal to pay less interest. However, you do have to make that a habit. For some, the upfront buy down gives them a consistent monthly payment.

Thanks,

Kevin Graham

The calculations also fail to account for the opportunity cost of the money used to purchase the points. If the funds were instead invested, the break even point gets pushed out even further.

$100,000 over 30 years at 6.00% will yield a monthly payment of $599.55. The same loan with a 5.25% will yield a payment of $552.20. This gives a monthly savings of $47.35. But, you paid $1,000 to get the lower rate. Divide the upfront costs by the monthly savings and you get 21.12 as the break-even point. This is not 16 months, as was shown in the article.

Similarly, most points equate to a reduction of 0.125%. So, for a $271,890 loan at 4.6%, you can buy a point for $2,718.90 to reduce the rate to 4.475%. Per the article, the break even point in years would be 1/0.125 = 8 years. But, do the math. The monthly payment on this principal with 4.6% is $1,393.83. The monthly payment with the lower 4.475% is $1,373.59. The monthly savings is $20.24. To pay off the $2,718.90, you need a little more than 134 months. That equates to a little more than 11 years … a full 3 years (or 37.5% longer) more than the approximation given by points/rate diff.

Calculations done with MS Excel 2010. Alternatively, you can do it by hand using c = rP/(1-(1+r)^-N), where c is the payment, r is the monthly rate, P is the principal, and N is the loan terms.

As is always the case, don’t take shortcuts when playing with this much money. Mr. Closson probably should follow his own advice and go back to math class.

Andy

You are absolutely right. . I appreciate your comment and I will do a couple of things.

1) Correct the math

2) Send you a Starbucks card for your help in keeping our site correct (if you like Starbucks)

Send me an email with your contact info and I’ll get your card in the mail.

Thanks again. Clayton Closson (claytonclosson@quickenloans.com)