Pay Points on a Mortgage If You Expect to Prepay?

April 19, 2004, Revised August 31, 2007"I was planning to pay 1 point to reduce the rate on a new 30-year FRM from 4.125% to 3.75%. I expect to be in the house about 7 years. Using your calculator, I get a break-even of 34 months. However, I expect to add substantially to my monthly payment in order to pay down this loan faster. Will this affect my break-even?"

Yes, it will lengthen the period before you break even – meaning that paying the point is not quite as good an investment.

Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, 1 point means a payment of $1,000. The more points a borrower pays, the lower the interest rate.

The benefit from paying points consists of the saving in monthly payment resulting from the lower interest rate, plus the lower loan balance in the month the loan is paid in full. The longer the borrower holds the mortgage, the greater the benefit.

For example, on December 28, 2006, I found that a 30-year fixed-rate mortgage at 5.75% and zero points was available at 5% with 3.76 points. If this loan was paid off after 7 years with no extra payments, the return on the investment in points would be 7.84%. This was calculated from 11c) Mortgage Points Calculator: Rate of Return on FRMs. If the borrower made an extra payment every month equal to 8.9% of the payment, which is the payment increase from moving to a 25-year amortization schedule, the return would fall to 7.26%.

So prepayments reduce the return on investment, but in most cases the reduction would not be enough to affect the investment decision. For a fuller discussion of the wisdom of paying points as an investment, see Is it True That Paying Points Doesn't Pay?