"Under what circumstances does it make sense to pay points?"

It makes sense if you have the money and expect to have the mortgage for 3-4 years or longer.

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, 2 points means a cash payment of $2,000). The more points you pay, the lower the interest rate.

Paying points can be viewed as an investment that yields a return that rises the longer you stay in your house. The return 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. This return can be compared to the return on other investments available to you over a similar time horizon.

On September 7, 2005, I took the following schedule covering 30-year fixed-rate mortgages (FRMs) from www.countrywide.com.  

Based on the table, a borrower could buy down the rate from 6.25% to 5.5% by paying 2 points. On a $100,000 loan the investment in points is thus $2,000, while the monthly payment would drop by $47.93. The reduction in the payment plus the faster reduction in the loan balance yield a return on investment of 6.4% over 3 years, 17.4%, over 4 years, and 28-29% over 8 years or longer.

Negative points are payments made by the lender to you for paying a higher rate. For example, the lender shown above will pay you 1.5 points for accepting a 6.875% rate rather than 6.25%. You can use the payments to defray settlement costs. This may be attractive if you are cash-short.

Where points that you pay yield a higher return the longer you have the mortgage, points that you receive cost you more the longer you have the mortgage. Over 2.5 years, you will be paying 2.9% for this money, rising to 12.7% over 3 years and to 23.0% over 4 years.

I have calculated returns from similar schedules covering a number of lenders and different types of mortgages. I found that in most cases, paying points is a good investment if you hold the mortgage 3 years, but in a few cases you have to hold it for 4 years. This holds for both FRMs and for ARMs with initial rate periods of 3 years or longer. Negative points are very costly unless you are out within 3 years.

I also found that differences between lenders are large. One lender offered better deals buying down the rate on a 15-year FRM than on a 30, while another lender offered the better deals on the 30. This is why it is a good idea to know exactly how many points you want to pay before you shop for a mortgage. Some more recent results will be found in Is It True That Paying Points Doesn't Pay?

You can calculate the return on investment in points by using my calculator 11c for FRMs (Mortgage Points Calculator, Rate of Return on FRMs) and 11d for ARMs (Mortgage Points Calculator, Rate of Return on ARMs).

Copyright Jack Guttentag 2007