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.