What's the point?

Posted: Jun 22, 2007 5:00 PM

My thoughts exactly, what is the point of people paying points on loans without having any basis for their action? People generally cannot define a point, haven't any idea how they can make up the cost of a point, and finally haven't a clue when to use a point and better yet, when not to. So here is the point! I am going to lay out everything that you need to know about a point, or points and hopefully save you from wasting money and help you to spend money wisely. This is a column that will save you or make you money which should make it one you keep and refer to often.

A point is one percent of a loan and every additional point is additional percentage points of the loan. Three points is three percent of the loan. Points are prepaid interest that are used to buy down the interest rate and lower your payment. The vast majority of points paid by borrowers end up as wasted money. The times that points are warranted and can be a great investment, they are generally ignored. I would like to see that change.

In my mind there are only three times to take a point or more. Two of those times you should pay for the point and the other time it is a gift. When buying a house you should always instruct your broker to include a sum to be paid by the seller for non recurring closing costs. I have seen the sum of 3% used as well as dollar figures such as $5000 or $10,000. Whatever you get you should use, in most cases, to buy a point or more to lower your interest rate and thus your payment. It is free money and you might even find a tax advantage in it as well. You needn't worry about earning back the money because it didn't cost you anything.

One of the other two times I recommend paying for points is when you are going to take a shorter amortizing loan as a 15 year fixed or 10 year fixed. The reason I suggest this is most people who take these loans keep them and pay them off. If it takes five years to earn back the cost of the point in monthly savings (lower interest rate means a lower payment) you still have five to ten years in profit ahead by having the lower interest rate and thus the lower payment. You can also keep your payment the same as it would have been without paying a point(s) even though you did pay the point and you will shorten your amortization and thus pay less interest during the life of the loan.

Before I get into the final reason to pay a point or more I must tell you that you shouldn't ever pay points on a 30 year amortization as it will general take five years on average to earn the money back in monthly savings and the overwhelming majority of people will have refinanced again for one of many reasons and thus waste the money they spent.

A worse scenario is paying a point or more for a 30 year and rates drop dramatically. You have an opportunity to really get a low rate for yourself but you haven't come close to earning your investment in points back so you hesitated to move hoping that in subsequent years you will have another chance after you have earned your money back. That is compounding a mistake in my estimation and yet I understand the reason for the hesitance.

The last of the good choices to exercise paying a point comes in a variable loan scenario.

Variables have a start rate, an index and a margin. The start rate for the most part is irrelevant (stay tuned), the index is the benchmark for changing the variable rate and the margin is what you add to the benchmark (index) to determine the rate at every change date.

You cannot influence the index (Libor, MTA, Prime etc.) as these are national or international figures set by the open market or in the case of Prime by the major banks.

What you can do to help yourself is buy down the margin and your interest rate (index plus margin) will be lower. Every time the variable changes wouldn't you rather add 1% to the index than 2%? That is what buying down the margin can do for you. Buying down the start rate might help in the beginning of the loan but after one or two rate changes it doesn't compare to a lower margin.

Points are deductible on purchases and must be amortized over the life of the loan on refinances. When you refinance a refinanced loan with points the life of the loan is over and any unused portion of the point(s) can be expensed in the year of the second refinance.

Example: $300,000 loan on a 15 year fixed with one point ($3000) will have a $200 a year deduction as the loan is amortized over 15 years. If after three years the house is sold and the loan is paid off or you refinance for some reason then $2400 that hadn't been expensed could be expensed at that time. A nice bonus of a tax deduction which few people even realized is available.

Points and their usage isn't rocket science but are nevertheless important for your financial well being. Use them wisely when you should and avoid them when they don't make sense and most people can feel that they did something for themselves by simply understanding the what (they are) and when (they should be used) as a financial tool available to you.