Is it worth paying points to buy down the mortgage interest rate?
My bank gave me a bunch of options for the mortgage to use points to lower the mortgage interest rate and the monthly payment. One option has me paying over $10,000 up front to get a $171 monthly savings on the mortgage payment.
Is paying points a good idea or not?
How do I figure out if paying the points is in my best interest?
Joshua Escalante Troesh, CFP | MBA
If you keep the mortgage for 30 years it is generally worth it, but almost no one does this for either their home or an investment property. If you sell the property in 3 months it doesn’t make sense to pay $10k in points to get a $170 monthly savings. The question is: How long do you need to have the mortgage to make paying that fee (the points) worth it - considering the time-value of money?
Paying points is a major decision; not only because it could cost you thousands of dollars in points if you shouldn’t have paid the points, but it could also cost you tens of thousands of dollars in extra lifetime interest expenses if the mistake is you should have paid the points. This is further complicated by the opportunity cost represented by paying the points - the fact you cannot use the money for other purposes.
You shouldn’t just look at how many months of savings it would take to equal the cost of points, as it is not a fair comparison. While this is better than not doing any calculations, it will give you a highly inflated value for paying points which will cause you to make a decision more in the bank’s favor.
You have to look at what else you could do with the money and consider tax consequences and inflation. This means doing a time value of money calculation to find the present value of the monthly future savings and comparing the net present value of the points and the monthly mortgage savings. (More Below)
Consider How Banks Calculate The Cost of Points and The APR They Offer
Banks are making a bet when they offer you points to buy down the APR on the mortgage. They estimate (based on a lot of data) how long they expect you to keep the mortgage and they offer you a deal where they break-even (or make a profit) on the points and mortgage APR options. If you sell the home or refinance the mortgage before their break-even point, then they win. If you stay in the mortgage longer than they anticipate, then they lose - and you win. And remember, the house generally wins.
How Do I Figure Out If Paying Points is Worth It?
Fortunately, this is a situation where you actually may have better information than the bank when making the decision. If you have a good idea of how long you are going to stay in the home or own the investment property, then you can calculate the net present value of paying each points offer (including possibly raising your payment through negative points) to maximize your potential benefit. To do these calculations you need 4 factors:
How long you will stay in the home
The rate associated with the alternative use of the points money
The tax-adjusted and inflation-adjusted value of the interest savings
The tax-adjusted value of the points
While the last two factors are easily solvable through doing some math on the bank’s offers, the first two factors are a bit more complicated.
How long will you keep the mortgage
Unfortunately, most people overestimate how long they will keep their mortgage. We always think our current home will last us longer than we expect (hence the crazy term ‘forever home’). And even if we stay in the home, the calculation is done on keeping the mortgage not the house.
Having more children, a job change, taking profit from selling the home, or simply future refinancing all impact how long you keep your mortgage. Banks bet and win on this overestimation all the time, so it is important to have an unbiased advisor who can talk you through a proper estimate.
Once the final calculation is completed, come back and consider the likelihood of you staying in the property for at least as long as is required for ‘break-even’ on paying the points. If break-even happens for you at month 54 and you think you will stay in the mortgage for 5 years, those numbers are too close together for it to make sense to pay the points. Life throws too many curveballs.
What is the rate of return on the alternative(s)
The next factor you need is the discount rate used in the net present value calculation. This should incorporate tax savings from mortgage interest, inflation, and the alternative use of the funds. If you have credit card debt you could pay off, then the interest rate (adjusted for inflation and tax savings) on your credit cards will be the proper discount rate. If you would stick the money in the bank, the tax/inflation adjusted APY on the savings account would be the proper discount rate. These two scenarios would net completely different results for the points calculations.
If you would reduce your 401(k) savings at work, the discount-rate calculation becomes a bit complicated because you would need to:
readjust for the lost tax benefit of contributing to your 401(k) and the tax cost at retirement
calculate the impact of any employer match on the annual rate of return
and factor in the risk associated with the variability of returns on investments
Adding in Income Tax Planning to Paying Mortgage Points
Tax planning is another consideration I take into account when advising clients on whether to pay points. When you are purchasing a new house the points you pay are potentially tax deductible in the year you pay them. Of course not paying the points allows you to spread that tax deduction over the period of time the client expects to keep the mortgage. While most CPAs will advise you to maximize tax deductions in the current year, it is better to consider multi-decade tax impacts (adjusted for the time value of money).
Choosing to pay points or not will also allow you to either front-load a tax deduction or spread the tax deduction over the time you expects to have the mortgage. Depending on my client’s personal tax situation and financial plan, we may choose one over the other as it saves on lifetime taxes.