When you take out a mortgage, you can lower the interest rate on the loan by purchasing points. One point is equal to 1 percent of the loan value. So, for example, on a $200,000 mortgage, 1 point would cost you $2,000, 2 points $4,000. Generally speaking, each point you pay upfront will decrease your interest rate over the life of the loan by about one-quarter of one percent. You pay the points at closing as prepaid interest. Points that you pay to purchase your primary residence can be deducted on your federal income tax return in the year you paid them. Points you pay to refinance your primary residence must be written off over the life of the loan.
Whether or not it makes sense to pay more upfront to get a lower interest rate over the life of the loan depends on how long you plan to stay in the home and how much cash you have to bring to closing. The biggest advantage of not paying points is that it reduces the upfront cash you will need to close the loan. For many people, the biggest obstacles to purchasing a home are the down payment and the closing costs. You may have the necessary income and credit to qualify for a mortgage, but lack the available cash on hand for the down payment and closing costs. In this case, a no points loan can help you get into the home of your dreams.
The downside to this benefit is that the points you don’t pay upfront get added to the cost of the loan in the form of a higher interest rate; significantly increasing your payments over the life of the mortgage. The longer you plan to be in the home and hold the loan, the more of an issue this will be. If you plan to sell within a very short time, a slightly higher interest rate will be much less of an issue for you since you will not be paying the higher rate for an extended period of time.
All things being equal, and assuming access to cash isn’t a problem for you, a no points option usually makes sense if you have a relatively short time frame that you intend to hold the mortgage. The longer you’re planning to make payments on the loan, the more likely you will find greater benefit in paying points and getting a lower interest rate.