What is a point?
One point equals one percent of your loan amount. Points are a one-time fee and are paid to the lender at the closing.
Many people are under the opinion that paying points is bad. Most have this opinion because its what they've been told. People are of the opinion that points are just a fee to the bank but they are more: they are a means to buy down the interest rate. The more points one pays the lower the rate. The question of whether you should or shouldn't pay points should be determined by cost analysis and a borrowers ability to pay points.
A borrower should pay points when his monthly savings adds up to more than the cost of the points. The key to figuring this out is to compare the two programs and compute the cost in points, the monthly payments, and finally the break even point.
Just like in choosing between a fixed rate program or an adjustable rate program timing is everything when it comes to the decision on whether to pay points or not. How long you will keep the mortgage and how much you can save per month if you pay them are the two main factors in determining if points are the right option for you.
If you pay points you will receive a lower rate and for many that should be the goal. Don't look at points as bad, don't think about what someone else may have told you. Do they benefit you in the financial obligation you are about to take on? This is the key, as with all of your options and strategies.
What is the Break Even Point?
The key to points is the break-even point. How much you will pay in points and how many months it will take to recoup that cost is what you need to determine. This information and an idea of how long you will keep the mortgage will give you your answer as to whether to pay points or not.
You will be obtaining a 30-Year fixed rate mortgage in the amount of $150,000. Should you pay points?
(Note:each point will be one percent of the loan or $ 1,500)
In this example the closing costs will be the same for each of the options so they are not applicable.
Option 1: 7.25% with no points
Option 2: 6.75% with 2 points
(do not worry if the rate options you are reviewing do not mathch these exactly, it's the difference in the teo rates which matters and this is should remain the same for higher or lower rates)
Step 1: Determine the payments and the difference per month
|OPTION ||POINTS ||PAYMENT
|OPTION 1 || 0 ||$1,023.26
|OPTION 2 || 2 ||$ 972.89
|Net Cost (opt. 2) ||$ 3,000 ||$-50.36
Step 2: Determine the break-even point (B/E point)
This will be determined by dividing the cost in points by the difference per month.
$ 3,000 divided by $ 50.36 = 59.5 or 60 months
If we have an idea how long we will keep the loan, we can determine which option makes the best sense financially.
Since 5 years is our break-even we know that the two programs will have the same cost if we keep the loans for 5 years. If we had chosen to pay points we would have paid $3,000 up front, if he had chsen not to pay points than the extra cost each month adds up to $3,000 at month 60.
The key is to look at your purchase and think about how long you plan on staying in the home.
Long Term Purchase
If we pay the points and are in the house for over 5 years we will save $50.36 every month that we keep the loan after month 60. If we don't pay points then we will pay $50.36 needlessly for every month we keep the loan after month 60.
If we keep the mortgage for 9 years and don't pay points we will pay $50.36 more each month than if we had paid the points. Over 9 years this cost would be $5,438.88. Compare that to the $3,000 in points we see that we can save $2,438 by paying the points up front and reducing our interest rate.
Short Term Purchase
If we plan on paying off the loan prior to 5 years then we will save $50.36 for every month between the date we pay off the loan and month 60.
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