January 10, 2000, Revised August 29, 2007"I have enough cash to increase my down payment from 5% to 10%, or to pay up to 5 points, but not both… Which is better?"

Paying Points and Increasing the Down Payment Are Investments

You can reduce or eliminate private mortgage insurance (PMI) if you increase the down payment, and you can reduce the interest rate by paying points. Both can be viewed as investments on which you make an up front cash outlay and receives a stream of income in the future. With a larger down payment, the income is the reduction in monthly payment that results from the smaller loan and mortgage insurance premium. With points, the income is the reduction in monthly payment that results from the lower interest rate.

As with any investment, you can estimate a rate of return. The better deal is the investment that yields the higher return over the period you stay in the home.

Factors Affecting the Return on Investment

The return on investment in points is extremely sensitive to how long you stay in the home. For example, suppose you are in the 28 percent tax bracket and pay 4.5 points to reduce the rate on a 30-year fixed-rate mortgage from 8 percent to 7 percent. If you stay in your house for 3 years, your after-tax return is a negative 17.8%. If you stay for 15 years your return is positive 15.9%.

The return on an investment in a larger down payment is much less sensitive to how long you remain in your house. For example, to reduce the mortgage insurance premium on the same mortgage from .78% to .52% of the loan amount, you increase your down payment from 5% of property value to 10%. The after-tax return over 3 years is 11.3% and over 15 years it is 10.9%.

Finding the Answer in an Individual Case

The moral is very clear. If your time horizon is short, you should invest in a larger down payment, and if it is long, you should invest in higher points.

How long is "long"? In most cases the crossover point where the returns are the same occurs in 8 years or less. However, the cross over point is affected by a number of factors including your tax bracket; PMI premiums; the rate reduction you receive for a given increase in points; and appreciation of your house, which affects how long you'll carry PMI.

You can analyze your own situation with three calculators:

12a. Rate of Return From Investing in a Larger Down Payment

11c. Rate of Return From Investing in Points on Fixed-Rate Mortgages

11d. Rate of Return From Investing in Points on Adjustable-Rate Mortgages