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. |
