I’m going through a refinance right now and was talking to the mortgage person about points and it dawned on me that this might not be well understood by many people. It is something that I’ve dealt with for a couple of decades now so it comes as second nature to me, but let me make an attempt to explain what they are.
Money like anything else in the world has a price. The price of money is an interest rate, or how much you get charged to use money. All loans have an interest rate on them based on many factors, but in the end they are charging you for the use of that money (you are renting the money). A mortgage is no different. Mortgages are generally cheaper than most other types of loans because its one of the safest kinds of loans for the person lending the money to do. Its safe because they have this nice property they can take and sell to pay back the loan.
If interest is renting money, then points are like paying for that rent up front. When you get a quote from a mortgage company they will sometimes give you multiple interest rates and have points associated with it, the more points the less the interest rates. I should stop here and explain that “One Point” is equal to 1% of the value of the loan.
So for example say you are getting a $100,000 mortgage. They quote you a price that is 3.5% with 2 points, or 4% for 0 points. This means that with the first rate you can pay 3.5% a year or $3,500 and up front you pay them 2% of the mortgage or $2000. The other option is no up front cost but you will pay $4000 a year. You can see by paying points you are kind of pre-paying some of the interest.
So what is the personal finance strategy here? Well paying points can be very useful if you know you will not be refinancing a loan for a very long time. In the example above it would only take you 4 years to make up the difference the up front points cost you and you can keep paying that lower rate out into the future. On the other hand, if you think there is a chance you might be refinancing or that rates could go lower in a reasonably short period of time than paying points don’t make as much sense. You can also take this strategy in the reverse direction, you can pay an even higher interest rate and get negative points or credits that can help pay for any loan costs so that you have a zero cash expense for your loan. You would do this, if you are pretty sure that there might be a refinancing opportunity in the next few years.
Why would a lender offer this flexibility? Behind the scenes they have models that make assumptions about how long the average person will hold a loan before refinancing. Offering points ends up just being a math equation, either you get the money now or later, it doesn’t make a huge difference economically to them.