How Points Work – to pay or not to pay, that is the question
Updated: Jun 3, 2019
What is a “Point” in lending? What does it mean when the bank suggests you “buy down the rate”, and does it make sense to do that? If you are offered a rate at no-points cost, is that always the best choice?
The purpose of this article is to explain how points work, so that you can decide what is best for you.
A Point is 1% of the loan amount. So, if your loan is $400,000, then 1-point cost would be $4,000. A Point is considered pre-paid interest, because your rate will be lower if you pay to “buy it down”. Here is an example of the choices you may be offered:
4.125% at no points cost
4% at 0.5-points cost
3.875% at 1-point cost
“Buying down the rate” means that you are paying the bank to offer you a lower rate than if you did not pay them. How do you determine if it is in your best interests to buy down the rate?
I calculate a “breakeven point” for my clients. That is the point where the money you save on the lower payment is justified by the money you spent to get it. Here is an example:
Your loan amount is $400,000 fixed for 30-years and you want to determine if it makes sense to pay 1-pooint to get 3.875%.
The payment at 4.125% is $1,936.60; 4% is $1,909.66; 3.875% is $1,880.95
The difference in monthly payment between 4.125% and 3.875% is $55.65.
The cost of 1-point is $4,000.
Divide the cost by the savings:
$4,000 ÷ $55.65 = 71.88 months, or about 6 years
In this case if you plan to keep the loan and the home for more than 6 years, then it may make sense to pay for the lower rate.
However, in real life it is a little more complicated. There are tax implications. Any points paid when you purchase a property are tax-deductible in the year you pay them. If you take the standard deduction on your taxes, this isn’t important. If you itemize your deductions or are buying an investment property, then you must take the tax deduction into account.
A simple example would be this. You itemize deductions and your tax bracket for State and Federal taxes is 40%. At the end of the day, you are paying 60% of $4,000 = $2,400
$2,400 ÷ 55.65 = 43 months, or about 3 ½ years
True “math geeks” will argue that principal is included in the payment and since interest is tax deductible in some cases, we need to account for those factors.
But my position is that this is a tool to determine the wisdom of whether to pay for a lower rate, not an exact science. I don’t want to complicate it unnecessarily. In real life, we have no way of knowing with certainty how long we will keep a loan or a property. Life happens. We can only do the best we can with the information available when we make the decision.
I hope this has helped you understand how points work. As always, if you have any questions please call me at 877-728-2008 or email CustomerCare@HollyGustlin.com