October 5, 1998, Revised November 7, 2002, November 27, 2006

"In your article about paying points, you said that the additional cash drain might be avoided by rolling the points into the loan. If there is no cash outlay, isn't the payment of points a no-brainer?"

Not necessarily. Although financing the points eliminates the cash drain, it remains the case that you must stay in the deal some minimum period of time to make it worth while. If you pay off your loan very quickly, the larger loan balance that you must repay will wipe out the savings from lower monthly payments. Indeed, in most cases the minimum period is longer when you finance the points than when you pay them in cash.

An Illustration of Financing Points

A borrower selecting a 30-year fixed-rate mortgage is offered a choice between 5% with 4 points, and 6% with no points. Assuming a $100,000 loan, the 6% loan has a payment of $600. Financing the 4 points on the 5% loan increases the loan amount to $104,167, but because of the lower rate the payment is only $559.

While the borrower saves $41 every month, the loan balance is larger on the 5% loan because it includes the points. If the loan were paid off after the first month, financing points would be a loser. The $41 saving over one month would be swamped by the $3942 difference in the balance.

Over time, however, the $41 per month saving builds up while the difference in the loan balance shrinks. A useful number for the borrower is the break-even period. How long must the low-rate mortgage with higher points be retained before the benefit exceeds the cost? The shorter the break-even period, the more advantageous is the lower-rate loan with points. This is the same question that should be asked when the borrower pays the points in cash, although the answer ordinarily will not be the same.

Break-Even Periods For Paying Points

Some break-even periods are shown below for different investment rates and income tax rates. The first number in each cell assumes the borrower pays the points in cash while the second number assumes the points are financed. These numbers are derived from my calculator 11a, The Costs and Benefits of Paying Points on Fixed-Rate Mortgages. They assume a purchase transaction (the tax treatment of points is slightly different on a refinance).

Break-Even Periods in Months on 30-Year Mortgages: 6% at 0 Points Versus 5% at 4 Points
Investment Rate	Tax Rate 0%	Tax Rate 28%	Tax Rate 40%
0%	49(63)	49(85)	49(103)
5%	56(59)	55(80)	54(99)
10%	68(55)	63(75)	61(94)

The table indicates that in most cases financing the points is less advantageous than paying them in cash. The exception is where the investment rate -- the rate the borrower can earn on his money -- is high and the tax rate is low.

Assumptions Underlying Break-Even Periods

The break-even periods when points are financed assume that financing the points does not raise any other costs to the borrower. Specifically, it cannot increase the loan from an amount below the maximum size loan eligible for purchase by the two government-sponsored entities, Fannie Mae and Freddie Mac, to an amount above that maximum. Rates are higher on loans exceeding the maximum, which was $417,000 in 2006.

Second, the increase in the loan amount cannot bring it into a higher mortgage insurance premium category. Mortgage insurance premiums are based on the ratio of loan amount to property value, with 4 premium categories: 80-85% (the lowest), 85-90%, 90-95%, and 96-100%.

Third, if you are refinancing, the new loan cannot exceed the outstanding balance on the old loan plus closing costs including points. If the new loan is larger than that, it is classified as a "cash-out refi" which will carry a higher rate.

If the larger loan that results from financing the points triggers an increase in the interest rate or the mortgage insurance premium, you don’t want to do it.

"I was offered a 'no-points on a refinance, but when I received the documents I found that the points and other closing costs were included in the loan balance…Is that customary?"

No Points Should Mean No Points

The practice is all too common, but I would not use the word "customary" to describe it. That word "customary" suggests that the practice is OK when in fact it is something of a scam. You are not getting a "no-points" loan because you are paying the points. The fact that you are borrowing the money to do it does not change this central fact.

That doesn't mean there is anything inherently wrong with financing points. The scam is in misleading you into believing that you are getting something for nothing -- a lower rate on your loan, with no cash outlay. You must repay money borrowed to pay points, as discussed earlier.