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Should you pay points? What are points? Is that money going directly into the Loan Officer’s pocket? Well, that depends. This article will look at these questions as well as a few others to see which strategy makes the most sense in the long run. We’ll also look at the math to calculate when points make sense and when they don’t.

Let’s start with the definition. A point is 1% of the loan balance. So if you’re getting a $500K loan, one point is $5000. The ‘standard closing cost structure’ will include one point. In fact, the first point is referred to as ‘origination’. The origination is the fee to ‘originate’ the loan. So that first 1% goes directly to the Broker. And depending on your Loan Officer’s volume, he or she will get some percentage of that money.

The remaining portion pays for the lights, the office space, the furniture, photocopier and so on. Part of that money goes to the Loan Officer and the rest pays for the office. That explains the origination. Anything beyond that is referred to as ‘points’ and points are actually prepaid interest; money that goes directly to the Lender. And in exchange for that prepaid interest, the Lender offers a lower interest rate, lowering your payment. We can calculate the breakeven for the decision. You either pay more up front and get a lower payment or you pay less up front and get a higher payment.

Before we look at the math, we have to address a couple of issues. For starters, the points and origination are tax deductible so they don’t cost you as much as it may appear at first blush. If you’re getting a $500K loan (1 point is $5000) and depending on your tax rate, that point may only cost you $3000 or $3500 on an after-tax basis. You’re either paying that money to the government or you’re using it to buy down your interest rate. When calculating the breakeven, always use the after-tax cost.

Secondly, one point buys different amounts depending on what loan you’re getting. If you’re getting a 30-year fixed mortgage, one point will reduce your interest rate by about 0.25%. With loans that are fixed for 5 or 7 years, one point will reduce your rate by about 0.375%. These are not exact figures. They vary by lender and by program. If you’re getting a 2-year fixed loan, one point would reduce your rate by a full 0.50%. The shorter the fixed period, the more one point will buy.

What’s the breakeven for buying the interest rate down? Well, for a 30-year fixed mortgage, the breakeven is usually between 3 and 4 years. In other words, if you sold the property or refinanced the mortgage within 3 or 4 years, you would’ve paid more money buying the rate down. The lower interest rate results in a lower monthly payment but it would take between 36 and 48 months to get the initial investment back. If you kept the house for longer than 3 or 4 years without refinancing, you would’ve recaptured the entire initial investment and be saving money each month for as long as you keep the mortgage.

For a 5/1 ARM or a 7/1 ARM, the breakeven is about 18 months to 2 years. That’s a much shorter period of time because one point buys more in these loan programs. For a 2-year fixed, the breakeven is usually just 14 or 15 months. So if you kept the mortgage for the first two years, you would’ve already saved money by buying the rate down at the beginning. Mathematically speaking, most people are better off buying the rate down.

The problem is that ‘points’ don’t sound very good. It sounds like you’re getting ripped off. Brokers know this so they generally don’t tell you the reality because they’re worried it’ll make their quote appear less competitive. But the reality is that they can help you save a bunch of money if you don’t refinance every year or two. And with lower interest rates behind us, the refinance boom is definitely over and people who refinance now should plan to keep their mortgages for as long as possible. Remember, it doesn’t matter what anybody tells you, refinancing costs money and you should try to do so as little as possible.

The industry has gone beyond avoiding ‘points’. They’re actually avoiding the origination as well. Again, the origination is the first 1% and most people mistakenly refer to it as a point, even though it’s technically different. Anyway, the industry’s been marketing ‘zero point’ loans for a few years already and most people jump at it, thinking they’re saving money. Well, the same math is true for the first 1% as for the second or even the third. If you’re not paying the 1% origination as a closing cost, rest assured, it’s hidden in a higher interest rate. Nobody’s doing loans for free out there and most banks have a minimum 1% origination anyway so you’re paying for it one way or another.

The reason this works is because Lenders pay Loan Officers rebates for loans with rates higher than the current market rate. Assume certain circumstances regarding credit, income and assets yields a market rate of 6.5% and the Loan Officer sells the loan with a rate of 7%, the Lender will pay the Loan Officer a rebate on that loan. If the closing costs do not include the origination, the Loan Officer just needs to raise the interest rate high enough to get a rebate of at least a 1%. And if they want to make more than 1%, they only need to raise the rate a bit more.

This goes even a step further when Loan Officers market ‘no cost loans’. Again, refinancing costs money and the fees associated with a purchase or refinance get paid one way or another so if they’re not itemized in the closing costs, they’re hidden in a higher interest rate. In today’s lending environment, you can mark up a loan so high that you get 2 or even 3% rebate after the loan closes. Don’t get fooled by ‘no cost loans’. It’s just a marketing gimmick.

There are four main categories of closing costs. First, you get the origination and any points you pay to buy the rate down. The second is the lender fees including underwriting and processing. Third, you get all the third-party fees like the credit report, appraisal, flood certification, notary and tax service. The forth category includes the escrow and title fees such as recording, settlement, courier and title insurance. For purchase transactions, there’s one more category for transfer taxes. In California, transfer taxes range from $1.10 per $1000 to almost $15 per $1000 in some municipalities.

For origination and points, you can calculate it yourself
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