Points are often a misunderstood concept for first time home buyers. Points are nothing other than interest paid up front (at the time of closing), to obtain a lower interest rate on a loan. One point is equivalent to 1% of the amount of money borrowed. If you are going to borrow $300,000 on your loan, one point would equal $3,000 up front. This generally generates 1/4 to 3/8 of a percent lower interest rate, depending upon the loan program.
When does it make sense to pay points? Paying points is a prudent financial move, if you are planning to be in the loan for a long period of time. Again, one of the most important questions to address when you borrow money is, “How long do you need to borrow this money?” This will answer the two all-prevailing questions you will have, which are 1) Should I pay points? And 2) What loan program is best for me? Notice that the question is not geared to, “How long do I plan to live in the home?” But more appropriately, “How long am I likely to be in this loan?”
How long you will be in the loan is not only affected by the tenure that 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 be able recuperate the total cost of the points in a period of time that is less than the amount of time you will need to borrow the money for.
Here’s an example. Let’s say you are going to borrow $300,000 for your mortgage, and choose to pay one point, which equals initial up front closing costs of $3,000. If paying one point up front saves you $100 a month, this means it will take you 30 months or 2.5 years, to recuperate the cost of the point that you paid. If you refinance the home any time before that 30-month mark, or decide to sell the home, you will have effectively wasted money. However, if you stay in the home for longer than a 30-month period of time, it is a wise financial move.
When deciding whether or not you should pay points, take into consideration where interest rates are at when you seek financing, and compare that to historical market trends.
When interest rates are at historical 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. Historically low rates, combined with the fact that you know you do not intend to move would indicate you will have longevity in the loan. It is unlikely rates will go down, giving you incentive to refinance.
Rates are cyclical. When interest rates are off of their historical lows, and higher than they generally are, we know that there is a strong likelihood rates will eventually come down. This is certainly no 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.