Should I Pay Points for a Lower Interest Rate?
by Evan Vanderwey on 27/04/10 at 4:37 pm
Last week I received the following question from a client – I get it a lot so I thought I would publish my email response.
“We have been talking about the new build home loan and the topic of buying down the loan interest rate has come up. We were wondering if you have guidelines that can help make the decision if buying points is worth the up-front expense.
Thanks again, we appreciate your time and your advice.”
Points paid by home owners when buying or refinancing their home are an up front cost with an “over time” benefit – and thus has a “break-even point” (a point in the future when the cost will be recouped by the savings).
Let’s say that you are borrowing $300,000 and the going interest rate is 5.25% with no points.
If you decided to pay one point – then your closing costs would be higher by $3000. (One point always costs you the equivalent of 1% of the loan amount).
You would then get a 5% interest rate, which in your case, causes your payment to get better by $46 each month.
To find the break-even point you divide the $46 monthly savings into the $3000 up front cost and you get 65 – that is 65 months, or 5.5 years – it takes 65 months of saving $46 each month in order to “get back” your $3000 investment.
But that isn’t the whole story – the future also changes some things – consider the follow in your decision:
1. The $3000 has an opportunity cost – if you don’t pay it in points – you could: pay down the mortgage with it, invest it in your IRA and earn a return, or spend it on landscaping, or something else. If invested, the value of the $3000 grows – this drives the break-even point out to 7, 8 or sometimes 9 years. That’s a long time to be behind.
2. Inflation is non-existent today, but in the future you could be dealing with dollars that are fixed on the mortgage and a lesser value in the dollar – that further drives the breakeven point out because the $46 is “worth less and less” and the value of what you spent the $3000 on becomes worth more and more.
3. You need to be able to afford it. If you don’t have the $3000 – then you can’t do it. And just “having it” is not affording it. If it’s your last $3000, then it would not be wise to spend it in this way. You want to make sure that you still have a good cushion or emergency fund. Make sure you can part with it before buying points.
4. Does the $46 make a big difference? Likely for you it won’t. If it is in fact the difference between affording or not affording the new home, then likely you are pushing the limits already and I would try to build less home.
I generally say NO paying points – either keep the $3000 liquid for emergencies or invest it.
Do I always say no? Well, no. Here are four things I like to see present before I recommend that folks pay them. Four are better than three, but I like to see all four . . .
1. You can afford it. You have the money for it.
2. Sometimes a point will give you more than ¼% rate reduction – not often, but when it does that shortens the break even point.
3. If you are getting a historically low rate. If rates are 7.5%, then I rarely recommend buying the rate down because historically it will only be a few years again before rates will improve and you could refinance for a lower rate at a cheaper cost.
4. You plan to be in the home for a long time. Because you will need a long time to realize the benefit.
Related posts:
