When Should You Pay Points on a Loan?

When it comes to comparing interest rates for a mortgage loan, homebuyers often have the option of choosing a loan with a lower interest rate by paying points. Simply put, a point is equal to 1 percent of the loan amount. For example, with a $100,000 loan, one point equals $1,000. Points are usually paid out-of-pocket by the buyer at closing.

Paying points may seem attractive, because a lower interest rate means smaller monthly payments. But is paying points always a good idea? The answer generally depends on how long you plan to stay in the house. Let’s look at an example:

Bob and Betty Smith are shopping for loan rates on a $150,000 home. Their bank has offered them a 30 year loan at 7.5 percent with no points. This works out to a monthly payment of $1,049.

However, their bank has also offered them a loan at 7 percent if they agree to pay 2 points (or $3,000). At this lower rate, their monthly payment drops to $998, or a savings of $51 per month.

By dividing the amount they paid for the points ($3,000) by the monthly savings ($51), we see that they will have to own the house for 59 months (or just under 5 years) before they will start to see savings as a result of paying points. If Bob and Betty plan to stay in the house for many years, then paying points could make good sense. But if they see themselves moving to another house in the near future, they’d be better off paying the higher interest and no points. (Note: for simplicity, the above example does not take into account the time value of money, which would slightly lengthen the break-even time.)

Can you deduct points on your income taxes?
In the United States, one side benefit of paying points on a mortgage loan is that they are fully tax deductible for the same tax year as your closing. However, this does not apply to points paid for a refinance loan. For refinances, the IRS requires you to spread out the deduction over the life of the loan. For example, if you paid $5,000 in points for a 30-year refinance loan, you can only deduct 1/30 of the $5,000 each year for 30 years. If you pay off the loan early, though, you can deduct the remaining amount that tax year. As to this page and all pages regarding tax situations, please check with your tax professional.

15-Year, 30-Year, or a Biweekly Mortgage?

In the past, the 30-year, fixed-rate mortgage was the standard choice for most homebuyers. Today, however, lenders offer a wide array of loan types in varying lengths–including 15, 20, 30 and even 40-year mortgages.

Deciding what length is best for you should be based on several factors including: your purchasing power, your anticipated future income and how disciplined you want to be about paying off the mortgage.

What are the benefits of a shorter loan term?
Some homeowners choose fixed-rate loans that are less than 30 years in order to save money by paying less interest over the life of the loan. For example, a $100,000 loan at 8 percent interest comes with a monthly payment of around $734 (excluding taxes and homeowner’s insurance). Over 30 years, this adds up to $264,240. In other words, over the life of the loan you would pay a whopping $164,240 just in interest.

With a 15-year loan, however, the monthly payments on the same loan would be approximately $956–for a total of $172,080. The monthly payments are more than $200 more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $92,000.

What are the advantages to a 30-year loan?
Despite the interest savings of a 15-year loan, they’re not for everyone. For one thing, the higher monthly payment might not allow some homeowners to qualify for a house they could otherwise afford with the lower payments of a 30-year mortgage. The lower monthly payment can also provide a greater sense of security in the event your future earning power might decrease.

Furthermore, with a little bit of financial discipline, there are a variety of methods that can help you pay off a 30-year loan faster with only a moderately higher monthly payment. One such choice is the biweekly mortgage payment plan, which is now offered by many lenders for both new and existing loans.

Biweekly mortgages
As the name implies, biweekly mortgage payments are made every two weeks instead of once a month–which over a year works out to the equivalent of making one extra monthly payment (compared to a traditional payment plan). One extra payment a year may not sound like much, but it can really add up over time. In fact, switching from a traditional payment plan to a biweekly mortgage can actually shorten the term of a 30-year loan by several years and save you thousands in interest.

If you’re interested in a biweekly payment plan, make sure to check with your lender. In many cases, lenders also offer direct payment services that automatically withdraw funds from your bank account, saving you the trouble of having to write and mail a check every two weeks.

Making extra payments yourself–do it early!
Another way to pay off your loan more quickly is to simply include extra funds with your monthly payment. Most lenders will allow you to make extra payments towards the principal balance of your loan without penalty. This is especially attractive to homebuyers who are concerned about their future earning power, but still want to be aggressive about paying off their loan.

For example, if you had a 30-year loan, you might decide to send the equivalent of one or two extra payments a year (which could shorten the overall length of the loan by many years). But if your financial situation suddenly took a turn for the worse, you could always fall back on the regular monthly payment.

One important note, though, is that if you do decide to send extra funds, make sure to do it EARLY in the life of the loan. This is because most home loans are calculated in such a way that the first few years of payments are almost entirely interest, while the last few years are mostly applied towards the principal balance. Thus, you can get the most bang for your buck by making the extra payments early in the life of the loan.