Paying points on a mortgage doesn’t always make financial sense. It just might save you thousands of dollars — or it could really cost you. This guide will help you understand what points are and help you determine whether you should pay extra for them at the closing table.

What are mortgage points?
How would you like to get a discount on your home loan? That’s the idea behind mortgage points. Also known as discount points, mortgage points are basically a fee you pay to your lender in exchange for a lower interest rate. A lower interest rate means you’ll have lower monthly payments over the life of your loan. (Origination points, on the other hand, generally refer to fees charged by the bank to cover the work involved in preparing your loan.) 

The reason you’re able to get a discounted interest rate in exchange for paying points is because the bank is happy to collect more money from you upfront as a lump sum rather than collecting small amounts of interest from you over the term of a loan.

If you choose to pay points to lower your interest rate, each point will cost you one percent of your home’s purchase price. So, for example, if you’re buying a $200,000 home, one point would cost you $2,000. Each point you pay generally lowers your interest rate by .125 percent. That means that a 6.5 percent interest rate would be lowered to 6.375 percent if you paid a point on it. 

There are three ways to pay for mortgage points: pay for them in cash at closing, negotiate to have the seller pay them for you or roll the cost into the total of your loan. If you roll the cost of points into your loan, that makes your principal balance higher. In our example, if you chose to finance the cost of paying a point, you would get a loan for $202,000, for instance.

Should you pay points?
In some cases, a bank might require you to pay points depending on the type of loan you want to procure. For most borrowers, however, paying points is optional and should only be done under certain circumstances. It’s important to note that paying points does not always make financial sense. For example, it doesn’t make sense for a homeowner to pay points unless he plans to stay in that home for a fairly long period of time.

To determine if you plan on staying in a home long enough to justify paying points, you can do some simple math:

• First, calculate how much your monthly mortgage payments will be if you do not pay points. (You can use a mortgage calculator to do this.)
• Next, find out how much your monthly payments will be if you do pay a certain number of points.
• Subtract the lower payment amount from the higher payment amount to determine how much you’d save by paying mortgage points.
• Finally, divide the amount you would pay at closing for the points by the amount you would save each month on payments. The number you come up with is the number of months you would need to stay in the house in order to break even on paying points.

Let’s look at an example. Say you’re buying a $100,000 home, and you’re taking out a 30-year fixed rate loan. At 7.5 percent interest and no points, the monthly mortgage payment would be $699.21. If you buy one point at a cost of $1,000, your monthly payment is lowered to $690.68, a difference of roughly $8.50. Divide $1,000 by $8.50 and you get 117. 117 months is almost ten years. In this example, you’d have to live in the home for nearly ten years before you could recoup the extra $1,000 you paid for points.

Another important point about points
Another thing to consider when you’re deciding whether or not you should pay points is that they are tax deductible. So paying points may help you save money in more than one way!