Question: My husband and I just signed a contract to purchase a home for $240,000. We plan on putting 20 percent down and are ready to apply for a $192,000 mortgage. Our real estate agent gave us an estimate of the closing costs and included two points. When we asked why we had to pay points, she said that paying points is the only way to get a low rate. Do you think we should increase our initial costs in order to get a lower rate?

Answer: First let me answer your question: No, I don't think it makes sense for most folks to pay points. Now, let me elaborate.

A point -- often called "discount point" or "origination fee" -- is equal to one percent of the loan amount. Points are charged by the lender and paid at closing.

Paying points allows a borrower to "buy down" his interest rate. The whole idea of points came about in the early 1980s when mortgage rates were in excess of 15 percent. The housing market came to a virtual standstill because people could not afford the monthly payments on such high rates.

To stimulate business, lenders began offering discounted rates with fees attached, called discount points. To get their houses sold, sellers were willing to pay the points charged by the lender. This enabled buyers to obtain affordables mortgage and owners to sell their homes.

Fortunately, times have changed. Interest rates are hovering around 7 percent, an affordable number by any standard, so there's not really a need to fork out a ton of dough in order to get a lower rate.

Let's run some numbers: Using today's market rates, you might find a 30-year fixed rate at 6.50 percent with two points. So, for the life of the loan, you get the awesome rate of 6.50 percent. You just need to cough up $3,840 ($192,000 x 2 percent) at closing in this example.

On the other hand, the same lender may offer you a rate of 7 percent with no points.

Which deal is better?

The monthly principal and interest (P&I) payment at 6.50 percent is $1,207. At seven percent the P&I payment increases to $1,270 per month -- a difference of $63 per month. If we divide $3,840 by $63, we find that it takes 61 months, or a little over five years to recoup your points in the form of a lower payment. This is called the "payback period."

But if we are to calculate a true payback period, we should assume that your $3,840 could make some kind of interest sitting in the bank. Let's say your bank is paying is paying three percent interest. A $3,840 balance would earn about $10 per month at three percent. If you pay points, this is interest you would never receive so we must subtract $10 from $63. Now divide $53 into $3,840 and our payback period increases to 72 months, or six years. That's a long time.

This is why I don't like points. Statistically, many folks don't hold mortgages for six years. Remember that points are never refundable, so if you do decide to sell your home or refinance before the payback period ends, you've lost money.

Unless you're 100-percent sure that you will hold this loan for at least six or seven years, I would suggest taking the higher interest rate and keeping your money invested.

Published: August 15, 2001

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