POINTS - To Pay Or Not To Pay, That is the question!

by Michael Eastham, CPA CRMS

It is no secret that the media and popular knowledge of the mortgage business tells us that points are always a bad thing and should be avoided like the plague.  Well, since I have never been one to submit to popular theory simply based on hearsay, let me tell you that that is a lie.  As always, it is critical to evaluate your individual investment strategy and consider the merits of several loan programs, scenarios within those programs and the total costs associated with each, prior to making a decision that is in line with your personal profile and objectives.

Let me first define what points represent. Points are an amount paid by a borrower that that reflect a percentage of the loan amount.  For example, 1 point based on a $100,000 loan is $1,000; 2 points equals $2,000, and so on. 

Now, I know what you are thinking.  Why would I want to pay points? Well, the benefit of paying discount points is a lowered interest rate.  That is the primary driving factor.  Another great reason is the tax savings.  Many times, the IRS views points as interest paid in advance and as such, it creates an additional tax deduction to the borrower.  As a result of these and other benefits, it makes perfect sense to consider paying some money now for the long term benefit of a lower monthly payment. 

One of the critical elements to consider when evaluating the merits of paying points is the pay back period.  In other words, based on the monthly cash flow and interest savings, how long will it take me to recoup the cost of those points?  Let me give you an example: on a $250,000 loan amount, if your lender offers you a 30 year fixed rate of 6% with no points or 5.625% with 1 point, your monthly savings will be about $60 by paying 1 point.  However, you cannot simply take the cost of the points and divide it by the monthly payment savings because that does not take into consideration the monthly interest savings and the allocation of principal and interest.  In this case, the break even point is just about 32 months.  If you plan to own the property longer than that then you will be better off by paying the point.

This comparison becomes even more dramatic when you compare a 30 year fixed rate mortgage to an Adjustable Rate Mortgage such as a 5 year ARM.  Before we do that, let me explain that a 5 year ARM is actually fixed for the first 5 years.  It will adjust periodically after that initial fixed period.  We will assume that the borrower plans to sell or refinance within the first 5 years so that the adjustable factor is a non issue.  Let’s take a look:  If you use the 6% rate from above and compare that to a 5 year ARM where you pay 2 points, which may yield an interest rate of 5%.  The savings in monthly payment now becomes $157 by selecting the 5 year ARM.  The pay back period on this option is only 2 years!  Remember, you paid $5,000 in advance to get that lower rate.

Now, let’s take this a step further to see what happens if you were to take that savings and invest it on a monthly basis in a reasonably safe investment vehicle at 7%?  This investment will grow to about $11,500 during that period.  That is pretty dramatic!  By simply matching the loan program to your strategy, paying some points to reduce the rate and investing the savings, you were able to earn a significant return on your investment.  Not only that, but you maintain control of your money, not the bank.

In Summary, the next time you are considering purchasing or refinancing real estate, make sure that you take the time to evaluate different loan scenarios to identify strategies that may be perfectly suited to your personal objectives in terms of risk and reward and you may find the answer to the question, “What’s the point?”