What are mortgage loan points?
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UPDATED: Feb 8, 2021
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When negotiating a home loan, the lowest available rates are usually only available if borrowers agree to pay “points.” Points are up-front fees equivalent to 1 percent of the entire mortgage amount.
So on a $200,000 loan, a single point equals $2,000.
If borrowers choose to pay more points up front, they are awarded with lower interest rates. Thus, they receive lower monthly payments throughout the life of their home loan. Conversely, if borrowers would rather not pay points, or do not have enough money on hand to pay for several points, they will be given higher interest rates on their mortgages.
According to Ginnie Mae, a single point usually reduces the loan’s rate by one-eighth of a percentage point.
When Should You Pay Points?
To make the most informed decision, do a break-even analysis to determine how many months it will take before the cost of your points pays off when compared with the savings they award.
To determine the time it will take to break even (in its most basic form), you would:
- Take the amount of savings per month that the points will award you (from the resulting interest rate)
- Divide that by the cost of the points
This will give you the amount of months it will take to break even.
For example, barring all additional costs, imagine you have a monthly payment of $3,000 and your lender tells you that points cost $5,000 each. He informs you that if you pay for two points, your monthly payment will be reduced by $100.
So you pay two points (a total of $10,000) and your monthly payment is reduced from $3,000 to $2,900 for a savings of $100 a month. Now divide the total cost ($10,000) by the monthly savings ($100), and you will get the amount of months it will take to break-even (100 months).
In this example, anything after 100 months (just over eight years) results in savings that would not have been possible without paying points.
As evident, the longer one has a mortgage, the more benefit they’ll receive from a smaller home loan rate.