June 22, 1998, Revised January 10, 2003, Revised Nov. 11, 2004, November 27, 2006

"A friend from the UK told me that over there mortgage borrowers don’t pay points, just an interest rate. Why do we have to pay points here?"

What Are Points?

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, 3 points means a payment of $3,000. Points are part of the cost of credit to the borrower, and part of the investment return to the lender.

Must a Borrower Pay Points?

Your friend is quite right in saying that points are unknown in the UK. In fact, to my knowledge, they are used nowhere except in the US. The international housing finance seminar that the Wharton School holds every May has hosted bankers and officials from at least 60 countries over the last 10 years, and none of them have been familiar with points.

But you are wrong in thinking that a borrower in the US must pay points. While the quotations you see in the press usually include points, the fact is that virtually all lenders are willing to make no-point loans if you ask for them. But of course the rate will be higher. The rate/point quotes you see in the media are what the lenders view as their "base" terms. But they have other rate/point combinations "in the drawer" to be trotted out when needed.

For example, a lender quoting 7.25% and 2 points might in fact be offering all of the following combinations:

6.75% and 4.50 Points

7.00% and 3.25 Points

7.25% and 2.00 Points (Quoted)

7.50% and 1.00 Point

7.75% and 0.00 Points

Lenders also offer negative points, or rebates, at even higher rates. These are discussed in Can Mortgage Points Be Negative?

Having the option to select from this type of menu in itself is a positive feature of the US system. The down side is that points add one more complexity to a process that is already complicated enough. The reason lenders usually keep all the combinations but one or two in the drawer is that they fear overwhelming the borrower – and perhaps losing the loan to another lender who makes it simpler.

Selecting the Best Rate/Point Combination

Some borrowers have little or no leeway because they are "cash-short" or "income-short". If they are cash-short, they are obliged to avoid points so that they will have enough cash to complete the deal. If they are income-short, they must accept the lowest rate available so that the mortgage payment won't be viewed as excessive relative to their income.

If you are not constrained in either of these ways, you should be guided by two factors. The first is your time horizon. If you expect to have the mortgage a long time, paying points to reduce the rate makes economic sense because you are going to enjoy the lower rate for a long time. If your time horizon is short, avoid points and pay the higher rate because you won’t be paying it for long.

How long is "long"? This is shown for you in calculator 11a, The Break-Even Period For Paying Points on Fixed-Rate Mortgages, and a companion calculator 11b applicable to adjustable-rate mortgages.

Note that you may have a short horizon because you expect to move soon, or because you expect that interest rates will soon drop and you will be refinancing. I don't advise basing your estimated time horizon on interest rate expectations because you can't forecast interest rates.

The second factor is your opportunity cost. What could you do with the money if you didn’t use it to pay points? Even if you expect to be in your house a long time, there could be other uses for your money that take precedence over the long-run savings from a lower interest rate.

A useful way to pull these factors together is to look at the payment of points as an investment that yields a return that rises the longer you stay in your house. This return can be compared to the return on other investments available to you. The return from paying points is shown for you in the calculator 11c Rate of Return From Investing in Points on Fixed-Rate Mortgages, and a companion calculator 11d applicable to adjustable-rate mortgages.