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Jul 22

Should I Pay Points?

Whenever you get a mortgage, you should ask yourself the question: “points or no points?”

A point is 1% of the loan amount, and it’s used to reduce your interest rate.

I think about it like 2 kids at the park, playing on a see-saw.  When one goes up, the other goes down.  In mortgages, the trade-off is between RATES and FEES.  The higher the rate, the lower the fees.  The lower the rate, the higher the fees.

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Paying points reduces your interest rate and your monthly payment.  However, it costs more up-front. How much more?  That is the question.  The fact is that mortgage rates change on a daily basis.  Along with them, the amount of interest rate reduction you will receive for points can vary widely.  It is a custom calculation every time.

The key is to balance a monthly payment you can afford with the cash you have available. For example, if you are borrowing $100,000, one point costs $1,000.  To figure out if it is worth it to pay that extra $1,000, look at how much it will lower your rate, and how much that lower rate will save you over time.

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In this example, the cost is $1,000, and the savings is .25% lower rate, and $15.59 per month.  Is that worth it?  It depends.  The first thing to ask yourself is “How long am I likely to have this mortgage?”  According to the experts, the average life of a mortgage loan is 5-7 years.  Most people end up either selling the house or refinancing before they have the mortgage more than 7 years.

The rule of thumb is to divide the cost by the savings, and if it works out to less than 60 months, or 5 years, it is worth it.  If we do that test here, $1,000 divided by $15.59 comes out to 64 months, or 5 years and 4 months.  You paid $1,000 to save $935.40 over 5 years.  Not a good trade-off.

Another, more accurate way of looking at the cost/reward trade-off is to look at “Total Cost.”  A total cost analysis takes into account the interest savings and the additional principal paid over the same period of time.

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Using this method, you can see that you actually come out $246 ahead by paying the points in our example.  That’s because not only did you save money every month in lower payments, but since you were paying less interest, you also end up owing $310 less on your loan at the end of 5 years.

Is it worth it?  It depends.  In the long run, you will have saved some money.  But in many cases, $1,000 in the hand now is worth more than $246 in equity 5 years from now.

Since this is a 30 year loan, how much would you save over 30 years?  Either way you go, you will have the loan paid off.  The only difference is how much you paid for it over time.  In our example, the $1,000 paid up-front in points turns into a 30-year savings of $4,608.

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