Why Pay Points?

When people ask whether to pay up-front "points" on a mortgage loan, it brings to mind an old motor oil ad. A mechanic is holding some worn engine parts and telling us why we should opt for the premium lubricant rather than Brand X.

"You can pay me now," he says, "or you can pay me later."

The same principle applies to the question about points. You can "buy" a lower interest rate today by paying a point or two (one or two percent of the loan amount), also known as an origination fee ("pay me now"). Or you can avoid the points today and accept a higher rate ("pay me later"). Unlike the motor oil question, this one has no obvious answer.

The following enlightened view comes from Jack M. Guttentag ("The Mortgage Professor"):

"Paying points can be viewed as an investment that yields a return that rises the longer you stay in your house. The return consists of the saving in monthly payment resulting from the lower interest rate, plus the lower loan balance in the month the loan is paid in full. This return can be compared to the return on other investments available to you over a similar time horizon."

Consider two offers for a $100,000 loan. Loan A has a lower interest rate of five percent, but you have to pay one point (or $1,000) to get that rate. Loan B has a higher rate of six percent with no points. Calculating your real return on that $1,000 investment depends on additional factors such as your tax bracket, but, assuming you stay in the home for 30 years, the annual rate of return on your $1,000 investment is better than 60 percent even after taxes. In this case the one-point fee is a tremendous investment.

The math is complicated, but the general conclusion is a no-brainer, especially when you use a mortgage payment calculator. With Loan B at six percent interest, the monthly payments come to $599. With Loan A at five percent, they are $536. Think of the $63 monthly savings as the "return" on your $1,000 investment. Now try to think of another way to make $63 every month for 30 years by investing $1,000 up front.

This example is an illustration, and usually the advantages aren't so stark. And, had you needed to relocate and left the house after a year, your $1,000 "investment" would have been a loser. But you get the idea. When considering points, think of them as an investment and then run the numbers.

If you'd like me to run some numbers for you, please do not hesitate to email me or call at 818-378-8669.