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When Interest Rates only tell Part of the Story - Understanding Points

When Interest Rates only tell Part of the Story - Understanding Points

When home buyers are looking for a new mortgage, or going to refinance an existing one, they typically pay close attention to the interest rate associated with it.  While the interest rate is one of the most important pieces of the mortgage agreement, it is not the whole picture in terms in what you will ultimately pay.  Did you know that points also play a role in how much you will ultimately pay for the house you are getting ready to buy?  Using points wisely can save you money in the long run if used wisely.

Each point that you buy will reduce your interest rates by 1/8th (typically) of a percentage point, thus to knock off 1% of your interest rate you would need to purchase 8 full points.  Each point typically costs 1% of the total mortgage amount.  Thus, if you are taking out a $200,000 mortgage one point would end up costing you $2,000.  In essence, you are paying the lender up front for a reduction in the amount of interest over the life of the loan.

So when does it make sense to use points?  They are usually only beneficial to the home buyer (in terms of saving money over the life of the loan) when the buyer intend to stay in the home for an extended period of time.  Those who plan to live in the home for less than 5-10 years may see no benefit at all, and actually end up paying more in the long run if they buy points up front.  Let's take a look at an example.

Suppose you decide to take out a mortgage for $200,000.  The rate you are quoted is 6%.  If you take out the mortgage for 30 years your monthly payment at 6% would be $1,199.10.  If you decide to purchase 4 points to lower your interest rate to 5.5% you would end up spending $8,000 to buy the points.   This will save you $63.52 per month in payment costs.  Thus you would need to stay in the house for at least 126 months (or 10.5 years) to get back your up-front investment of purchasing the points.  Over the life of the mortgage note, you would end up paying $208.808.08 interest with the points versus $231,676.38 without for a savings of $22,868.30 in interest over the life of the loan. 

When deciding on whether or not to purchase points up front the general rule of thumb is to approach it from a conservative point of view.  Nowadays people are moving more often and the house you buy today probably won't be the same house that you stay in all of your life.  Some experts suggest that you should only buy points when the payback period is less than 5 years.