Should I Pay Points?

There is an inverse relationship between points and interest rate on your loan. The higher the points you pay, the lower the interest rate, and vise versa.

There are fees other than points associated with a loan transaction, but for a given loan amount and service provider, these other fees are fundamentally fixed. Other fees may include appraisal, credit report, lender's inspection, tax service, processing, underwriting, wire transfer, flood certification, title and escrow fees, notary fees, recording fees, etc. For example, consider a $100,000, 30-year, fixed rate loan on a home valued at $200,000. No matter what the points and interest rate you pay, an independent appraiser won't give you a "zero-fee appraisal", nor will a title company give you rebate pricing for a policy of title insurance.

Because of the inverse relationship between points and interest rate, you can obtain a rebate from the lender to cover some or all of your points and other fees. By increasing the interest rate on your loan, the lender might pay some or all loan fees. By reducing the interest rate on your loan, you'll pay some or all of the loan fees.

As a borrower, you should answer these questions before you commit to a new loan: Should I obtain a lower interest rate, pay points, loan fees, or both? Should I get a higher interest rate and reduce out-of-pocket fees? To answer these questions, estimate how long it will be until you plan to sell or refinance. The task then becomes finding the interest rate / fee combination which is the least expensive during this window of time.

Here is a hypothetical example. For simplicity, "other fees" are fixed at $1,000. You own your home and are interested in refinancing your high-interest loan to take advantage of a new, low-interest loan. The interest rates for zero point / zero fee loans are well below your current rate, so you know it's time to refinance. Your employer has indicated you might be transferred in approximately three years. You compare three rate / fee combinations to identify which is the least costly over the next three years. You're considering a 30-year, fixed loan.

Comparing the expense of different loans allows us to consider only the interest portion of the monthly payments. The principal portion of the monthly payment is not considered an expense. Therefore, only the interest portion of the monthly payments are considered in these examples. A financial calculator or spreadsheet program can provide the interest portion of the monthly payments. Here are the loan comparisons.

Loan: 30-year, fixed, $100,000, 8.0%, monthly P&I payment = $733.82
Month		1	2	...	23	24
8.0%	Interest	666.67	666.22		656.11	655.59
	Points	0
	Other Fees	0
	Cumulative Total	666.67	1,332.89		15,214.70	15,870.29

Loan: 30-year, fixed, $100,000, 7.5%, monthly P&I payment = $699.28
Month		1	2	...	23	24
7.5%	Interest	625.00	624.54		614.10	613.57
	Points	0
	Other Fees	1,000
	Cumulative Total	1,625.00	2,249.54		15,252.35	15,865.91

Loan: 30-year, fixed, $100,000, 7.0%, monthly P&I payment = $655.37
Month		1	2	...	23	24
7.0%	Interest	583.33	582.86		572.14	571.60
	Points	1,000
	Other Fees	1,000
	Cumulative Total	2,583.33	3,166.19		15,290.61	15,862.21

The cumulative total for each loan represents the total expense related to the loan at the end of a given month. Initially, the expense of the 8 percent loan is much lower compared to the others because the 8 percent loan is free of out-of-pocket closing costs. The 7.5 percent loan is a zero point, $1,000 closing costs loan. The 7 percent loan example requires the borrower to pay points and fees. Initially, the 7 percent loan is the most expensive. At the end of month twenty-three, the 8 percent loan is still the least expensive. At the end of month twenty-four, the 7 percent loan is the least expensive. If we were to carry out these examples, the 7 percent loan would continue to be the least expensive. This comparison suggests that you should take the 7 percent loan. You'll be in your home for three years, and beginning in the second year you start saving money with the 7 percent loan.