- The Washington Times - Thursday, August 4, 2005

Q:We have been renting for the past 10 years and have finally decided to wise

up and by a home. I have been reading up on mortgages and have determined that paying as many points as possible in order to get the lowest interest rate is the best move. But I have read in your column that you advise against paying points. Can you explain?

A: Certainly, but let’s first summarize.

A point is a cash payment equal to 1 percent of the loan amount that is paid to the lender at settlement in return for a lower interest rate on the note. The more points you pay, the lower the note rate. A more descriptive term is “discount points” because the payment of points allows for a discounted, or below-market, interest rate.

Points became popular in the late 1970s and early 1980s, when mortgage rates skyrocketed to 17 percent and 18 percent. During this inflationary period, the high interest rates made homeownership unaffordable to many consumers. The housing market was dead.

Seeking to generate business, lenders started offering lower rates with discount points. Homeowners and builders, eager to sell their property, offered to pay the points to the bank in order to attract more qualified buyers.

Back in those days, it wasn’t uncommon for a seller to “buy down” the interest rate with a payment of four or five points. The emergence of points paid on a mortgage evolved through the necessity of affordability.

But times have changed. Over the past 10 or 15 years, mortgage rates have averaged, perhaps, 6 percent or 7 percent and have rarely exceeded 9 percent. During the 1990s, when the stock market was booming, it made far better sense to take a higher mortgage rate and invest money rather than sink it into points.

Despite the anemic performance of the stock market during the past five years, I still recommend against paying points to buy down an interest rate.

Let’s look at some numbers.

At this writing, you might be able to find a 30-year, fixed-rate loan in the amount of $300,000 with a rate of 5.50 percent with no points. On average, it will cost 1.25 points for every quarter-percentage-point drop in interest rate.

Paying 2.5 points, for example, would lower the interest rate to 5 percent. The principal-and-interest payment at 5.50 percent is $1,703. At 5 percent, the P&I drops to $1,610, a difference of $93 per month.

But it will cost you 2.5 percent of $300,000 in cold hard cash. That’s equal to $7,500. If you divide $7,500 by $93, you see that it would take 81 months — nearly seven years — to recoup the points paid with the lower payments.

The payback period is much longer if you take into consideration the fact that the $7,500 can earn a return if invested properly. Even a meager 3 percent return would earn $19 per month. Subtract $19 per month from the $93 payment savings, and you find that you really save only $74 per month.

This increases the payback period to almost 8½ years.

These calculations illustrate one thing: If you are prepared to pay points to lower your interest rate, understand that you must hold the loan for at least nine years before any benefit kicks in. If you sell or refinance before you recoup your points, you have lost money.

I’m leaving out one thing. On a purchase, points are usually 100 percent deductible in the year of the purchase, so a buyer would receive a considerable tax break in the first year. But remember that taking the higher rate means that more interest is paid over the life of the loan, so the tax benefit of paying points is largely offset.

I view paying points as merely giving the bank a layaway fee to receive a future, improbable benefit. Don’t do it. Keep your money and ignore the points.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by

e-mail ([email protected]pmcmortgage.com).

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