Points can often be a misunderstood concept for first-time home buyers. Points are interest paid upfront at closing to obtain a lower interest rate on a loan. One point is equivalent to 1 percent of the amount borrowed. When borrowing $200,000, one point would equal $2,000. Depending on the loan progra, one point generally generates 1/4 to 3/8 of a percent lower interest rate.
When does it make sense to pay points?
Paying points is a prudent financial move if you plan to be in the loan for a long period of time. The question is not “How long do I plan to live in the home?” but rather “How long am I likely to be in this loan?” How long you will be in the loan is not only affected by the time you own the home, but also the probability of seeking a refinance at some point in the future. As a general rule of thumb, you will need to recuperate the total cost of the points in a period of time less than the amount of you time you will need to borrow the money.
If you are going to borrow $200,000 for your mortgage and pay one point, your initial upfront cost would be $2,000. If paying one point saves you $100 per month, that means it will take you 20 months to recuperate the cost of the point you paid. If you refinance the home any time before the 20-month mark, you will have effectively wasted your money. However, if you stay in the home for longer than a 20-month period of time, it is a prudent financial move.
When deciding whether you should pay points, take into consideration where interest rates are when you seek financing, and compare the rate to historical market trends. When interest rates are at historic lows, it makes much more sense to pay points, especially if you think you will live in the property for an extended period of time.
When interest rates are higher than they generally are, we know that there is a strong likelihood rates will eventually come down. This is certainly not a good time to pay points. The chances of refinancing at some point in the future are extremely high, and therefore, you would not need to be in this loan for a long period of time.
