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Paying Points

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The issue of paying points on your mortgage is one that every borrower, first-timers and veterans alike, is going to have to deal with. Paying points has its pros and cons (as do so many things in the world of mortgage), but the circumstances of a refinance may make paying points a much worse idea.

What are Points?

A point is worth 1% of the principal of your mortgage. If your loan has a $250,000 principal, one point would be $2,500, two points would be $5,000, and so on.

One pays points at the beginning of a new mortgage in order to lower the overall interest rate. The money, rather than going to pay off the principal (like a down payment), is incentive for the lender to lower the interest rate, making your loan total and monthly payments lower.

Did You Know? Points are not tax-deductible as a lump sum; the write-off will be amortized over the period of your loan. Keep this in mind when deciding whether or not to pay them.

How Does Refinancing Affect My Decision?

In order for paying points to be financially worthwhile for you, you need to keep your loan long enough for the savings on interest to exceed the up-front cost of paying the points. For example, if you pay two points on that $250,000 mortgage, you should have saved $5,000 in monthly payments by the time you refinance again, sell the house, or pay everything off completely.

Generally, borrowers don't stick with their refinanced loans long enough to make paying points worthwhile. Since you aren’t paying down principal when you pay points, you aren’t building any equity. That means you'll only see the benefit years down the line when you’ve paid enough of your loan off that some savings occur. Unfortunately, statistically, you are more likely to have refinanced or sold your home by then.

To avoid this, calculate the break-even period. This will show you how long you need to make payments on your loan until your savings on interest equal what you paid up-front. Once you find out what your lender is offering in terms of a rate reduction, you can calculate how long it would take to make paying the points worthwhile. Then, you can make a decision based on where you see yourself at the break-even period.

The basic rule of thumb is this: if you decide to pay points up front, you should be very confident that you will be making payments on this particular mortgage for a while. It is quite common for borrowers to end up paying more in the long run because they didn't inspect the break-even period closely enough. However, if you plan on staying in this house with this mortgage for a long time (and you have some extra cash up front), paying points might be the right decision for you.

Patrick Hanan  Posted by Patrick Hanan on June 15, 2010

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