Do the Math on Mortgage Points

When you take out a new mortgage, the lender may offer to reduce your interest rate if you are willing to put up cash to buy "points."

Should you take the lender up on that offer?

The decision to pay points at the start of your mortgage depends largely on how big an interest rate reduction you will receive, and how long you plan to stay in your new home. In some cases, it might make more sense for you to use any spare cash to increase your down payment.

Each mortgage point (also called a discount point) represents 1% of your overall loan. Paying a single point typically lowers your interest rate by 0.125%, although points sometimes can buy you a larger rate cut.

The amount of interest you save by lowering your rate depends largely on how long you hold the loan. It might make sense to buy points if you are sure you will live in your house long enough for the savings from the lower interest rate to significantly outweigh the cost of the points you purchased. If you plan to sell too soon to recoup your costs, then buying points is probably a poor idea.

One alternative is to put your extra cash into a larger down payment. That way, you own a larger slice of the house, which could improve your financial return -- depending on when you sell the place.

The Mortgage Points Calculator from BankingMyWay.com can help you figure out whether to buy points or make a bigger down payment.

The calculator figures out the difference in monthly payments between the two scenarios -- buying points vs. taking out a reduced loan amount. It requires you to fill in the number of years you expect to live in your home. It then calculates what you save (or lose) over various time periods if you choose to buy points rather than use the same cash to make the bigger down payment.

Take, for instance, a 6.5% 30-year $200,000 fixed mortgage. Paying two mortgage points would cost $4,000, lowering your rate to 6.25%. That makes your monthly mortgage payments $1,231.43.

If you instead use that $4,000 to increase your down payment, you keep the same rate of 6.5%, but your loan amount is now only $196,000. Under these conditions, your monthly mortgage payments are $1,238.85 ($7.42 higher per month than the points option).

If you plan to live in your home for just five to 10 years, you stand to pay an extra $2,752 to $1,424 if you buy points. Alternatively, if you live in your home for 20 years, buying points will save you $1,209, and staying the full 30 years nets a savings of $2,671. The break-even term where the two options are roughly equal occurs during the 15th year of the mortgage term.

Make sure your decision takes into account the tax advantages of buying points. If you itemize on your tax return, points bought at closing are fully deductible in the year you buy your home (subject to a few conditions that you can read about on the IRS web site).

If you pay $4,000 to buy points, you could save a significant sum in taxes -- for example, you'll lower your tax bill by $1000 if you are in the 25% tax bracket. So you should increase the benefits of points by that $1000 when you are evaluating the calculator's conclusions. In our example, doing so shifts the break-even term in the above scenario to 11 to 12 years, at which time buying points becomes the right decision.

One last thing: Some lenders automatically include points when they quote attractively low interest rates on the mortgages they offer.

So bear that in mind when you're comparing advertised rates.