When Should You Pay Points on a Mortgage | Common Mortgage Mistakes
I have been a Loan Officer for 20 plus years and have seen people make many common mortgage mistakes. This blog is going to cover examples and help you answer the question, “Should you pay points to lower interest rate?” In the interests of educating you to better understand how to preserve your home’s equity, I chose to write on this topic as it is complex to debate. I hope this blog will help you better understand:
- When should you pay points on a mortgage?
- Types of points: origination and discount points.
- Is it smart to pay points on a mortgage?
- How to avoid the common refinancing mistakes of paying needless points.
- What are the consequences of paying the loan off before you “break-even” on the points paid at closing?
- Should I pay points to lower interest rate – is it worth the cost?
Difference Between Discount Point and Origination Points
For the purposes of this blog, we are going to focus on discount points because origination points are not used to lower your interest rate but are points paid to compensate the lender. To differentiate the two types of points:
Discount points: points paid at closing that allow the bank to discount/lower your rate – not to generate more profit.
Origination points: points paid at closing that could be for anything else – often extra lender compensation.
Is it Smart to Pay Points on a Mortgage – Discount Points
This is a great question and the decision on if you should pay points, which should be considered carefully, before you are talked into paying discount points. Generally, if you do not have plans to live in the property for a significant amount of time (i.e.- five plus years) I would advise against it. I use five years as a baseline because that is about the average time it takes to recoup the cost of a point paid.
To wisely decide if paying points is for you, simply ask your lender to let you know exactly how much money per month it would save you to pay a discount point. Then, divide the amount of your point(s) by that monthly savings the point provides, and that number will represent how many months it will take to break even on the point cost.
So, if you pay a discount point of $2,500 for a $250,000 mortgage loan and only are saving $45/mo. The math will tell you that $2,500 / 45 = 55.5 months to break even (almost five years). Keeping this in mind, let us use another example to help you get a more clear understanding on how to debate whether to pay points or not.
Paying Off Your Loan Before You Break Even – Example
Unfortunately, with the rates at current record lows at the time of this writing, this is the harshest refinancing mistakes I have seen many of my new refinance clients suffer. One recent example that I can recall is a VA loan I provided for a veteran who refinanced less than 2 years previously. Here is how that previous refinance was structured:
- The borrower paid 2.5% discount points.
- Just closed on a refinance 16 months prior to the new loan.
- Loan amount was $400,000.
- The 2.5% in points paid at closing increased his loan amount by $10,000 (2.5% discount points).
- Purpose of the loan was to refinance to a slightly lower rate and to pay off 5 credit cards (debt consolidation).
Now, in this example above, the borrower was purely focused on monthly payment and out-of-pocket cash at the close. The illusion was, the borrower did not feel the $10,000 come out of their pocket, however, they realized a loss of over $8,000 when we closed their new loan, since they failed to recoup even $2,000 of the points paid at closing over the 16 months they owned the old loan.
Paying Unnecessary Discount Points
Paying the points on the old loan was an oversight due to the borrower seeing that their overall bill payments per month were being reduced significantly with the elimination of the five credit cards. So that was why they went for it and presumingly, why they were not focused on the fact the $10,000 in points were being added to the loan.
After asking why the borrower agreed to pay the points, they were told that they had to pay the points to qualify because they were doing a cash-out/debt consolidation refinance – that simply was not true. Also, the offer to pay points seemed more appealing to them because the interest rate was more than half a percent lower than if they did not pay points. Since the cost was rolled into the loan, there was no out of pocket costs at that previous close, but the truth is that they were still paying closing costs by financing them. Note: the 2.5% they paid in points, only saved them about $120 per month.
In all events, I was able to lower the rate by over a full point and not charge any points, which made the decision to refinance again very sensible, despite the loss from paying points on the previous loan.
When Should You Pay Points on a Mortgage
Depending on the Loan Officer, this is very subjective. I know many Loan Officers that encourage their borrowers to pay points in almost all instances. I am on the other side and usually have people avoid it unless they absolutely have to or they clearly plan to live in the property with ample time to break even and start to enjoy the savings.
I would say in most cases, paying points does not reduce the interest rate significantly enough to justify the immediate cost of paying or rolling points into your loan. Points paid at closing are considered one of the closing costs for a mortgage. Understanding closing costs can be a difficult subject due to all fees varying on a loan.
To be more direct, I usually never suggest it, unless some notable considerations that could justify paying point(s) exist, which leads us to the conclusion.
Should I Pay Points to Lower Interest Rate – is it Worth the Cost?
I bet many readers of this are realizing that they may have points paid at closing in the past, needlessly. If so, you certainly are not alone and that is why I wrote this. I have seen too many cases where money has been wasted on points and sharing the criteria needed to evaluate this debate empowers you to prevent from making the same mistake again.
Mortgage lending has been my only career since I graduated college and my goal is to see the business become more transparent and ethical as we keep moving into the future. I view my job as a service, not a sales process. Keeping my fees low, doing more loans at a discount versus being as profitable as possible.
Keep in mind I have seen the industry evolve into more of a sales model versus a financial planning model. Many Loan Officers will simply charge points to make more money if you let them. Please remember the examples used in this analysis and apply the calculation on the break-even months, if you are considering paying points for a lower rate.