First of all, let me explain what a “point” is. A point is a fee that you pay to lower your interest rate.
Zero points would cost 0.00% of the loan balance. One point would cost 1.00% of the loan balance. Two points would cost 2.00% of the loan balance.
For example, if you have a mortgage of $200,000 then 2 points would cost $4,000 ($200,000 x 2.00%). If you paid 2 points to lower your interest rate, then your mortgage balance would actually increase from $200,000 to $204,000 (unless you paid the points out of pocket).
Using the same example above, lets assume that you wanted to refinance and you were wondering whether to pay 0 points or 2 points. Let’s also assume that you wish to refinance to a 30 year loan and that the interest rate on a 0 point loan is 3.50% and that the interest rate on a 2 point loan is 3.00%.
If you refinance with a 0 point loan then your mortgage balance would remain unchanged at $200,000 (please note that we are ignoring closing costs for simplicity) and your payment would be $898 per month. If you refinance with a 2 point loan then your mortgage balance would increase to $204,000, but your payment would decrease to $860 per month. Even though the loan balance increases, your payment is approximately $40 less per month. So, does it make sense to pay points to lower your interest rate?
Interestingly enough many people have an aversion to increasing their loan balance and as a result they shy away from paying points. However, both loans (the 0 point option and the 2 point option) will be paid off in exactly the same amount of time (30 years). So, the bottom line is that if you plan on being in the house for at least 9 years or longer (this is the amount of time it would take to recoup the cost of paying points), then going with the 2 point loan is likely your best bet. If there is a chance of not being in the home for at least 9 years, then don’t pay the points.
Everyone’s situation is likely different; therefore, it’s important that you evaluate this decision in light of your unique circumstances.
Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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Photo courtesy of J. Stephen Conn