Points, also called loan discounts, are sums of money paid up front when obtaining a loan in order to achieve a lower interest rate. One point is equal to one percent of the mortgage loan amount. For example, one point for a $150,000 loan would be equal to $1,500. Two points on the same loan would be $3,000 and so on. Most loans will have the option to pay around 1-3 points.

The lower interest rates that paying points affords may look appealing to many home-buyers. For homebuyers who plan to keep their original loan for a long time, and stay in their newly purchased home for a while, paying points may make sense and reduce overall interest. However, if a buyer moves again in a couple of years, or refinances early on, the lower interest rate may not save enough money on monthly payments to cover the cost of points.

Points originated due to skyrocketing interest rates for home loans. The high rates practically froze the home market as few people could afford to take out loans with such high interest rates. Homesellers also suffered, as they could not sell their homes. The point system allowed for two options that reinvented the home market: homebuyers could pay for points themselves and reduce their interest rate, or an agreement could be made whereby the seller would pay some of the points for the buyer, to encourage the purchase.

Points made a lot of sense when interest rates were up around 15 percent in the 1980’s. Today, however, interest rates are hovering around 7 percent or so, a very reasonable rate. Breaking even on a point investment may take a little more time than it used to. Let’s compare paying $3,000 (2 points) up front on a $150,000 loan to buy down a lower interest rate of 7%, and paying no points on that same loan but assuming the higher interest rate of 7.5%. The lower interest rate gained by paying points will reduce your monthly payment by about $50. If you divide the amount paid up front ($3,000) by the amount saved per month ($50), you will find that it will take you 60 months, or 5 years to begin reaping the benefits of the points you paid. At this time, points are fully deductible as mortgage interest on your income taxes, in the year that the points are paid. If you itemize, this deduction will reduce the income taxes you pay that year, thereby shortening the payback term. However the cost of points does not take into account the added interest you could have accumulated by having the money you paid for points, in the bank instead, for an additional 5 years.

Unless you are sure that you will keep your loan for more than 5 years, in this case, points are probably not a good idea. In today’s society, most people cannot guarantee that they will keep their original mortgage for that long due to refinancing options and the possibility of moving. Once points are paid, they are non-refundable and unless the lower interest rate starts paying off before the mortgage is terminated for one reason or another, the homeowner will lose money in the deal.

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