What's the value in paying points?

Mortgage points can enable you to access a lower interest rate on your new loan whether you're buying a home or refinancing. But points aren't free. Should you pay them?

The answer depends on your personal situation; however, there are some general guidelines that can help you make a smart decision.

A point is an upfront fee equal to 1 percent of your loan amount. If you borrowed $200,000, one point would be $2,000, half a point would be $1,000, a quarter point $500.

As a mortgage shopper, you'll naturally want to get the lowest rate you can. But points and fees associated with various loans are an important reason why you shouldn't shop based only on the lowest interest rate.

How points affect your mortgage loan rate

Points can affect your rate in two ways. Discount points allow you to get a lower rate. This is known as a "buy down" or "buying points." Rebate points allow you to accept a higher rate in exchange for a credit at closing. If you choose, you can apply the credit to your closing costs.

"You can take a loan with no closing costs," says Justin Lopatin, vice president of mortgage lending at PERL Mortgage in Chicago. "But what you're asking is to finance those costs. You're taking a slightly higher rate, and you're paying the costs every month in that rate."

One point paid today usually shaves no more than a quarter or eighth of a percentage point off your rate. That ratio isn't a constant. The ratio applied to your loan depends on market conditions, market rates, your lender's policies, and the type of mortgage and term you choose.

"The only danger with buying points is if you plan to refinance or sell your home before the point has paid for itself," says Jennifer Beeston, a vice president of mortgage lending at Guaranteed Rate Mortgage in Santa Rosa, Calif.

Points impact interest, equity and loan size

HSH mortgage expert Keith Gumbinger offers this example:

Let's say you've been approved for a 30-year, $200,000 mortgage at 4.25 percent interest with no points. For the sake of this example, we'll assume that one point will raise or lower your rate by 0.25 percent.

You have three options:

1. Pay $2,000, one discount point, in addition to your closing costs for a lower rate of 4 percent.

2. Pay no points, leaving your rate unchanged at 4.25 percent.

3. Receive $2,000, one rebate point, at closing, in exchange for a higher rate of 4.5 percent.

Compared with the no-points option, paying one point produces $4,487 of lower interest expense and improved equity over the first seven years of your mortgage. That's a return of more than double your upfront cost of $2,000. Conversely, receiving one rebate point costs you an additional $4,387 in higher interest and lost equity over the same seven-year period. That's a lot more than $2,000.

Paying points can also help you get a bigger mortgage with the same level of income. That might let you buy a bigger, more desirable home in a neighborhood with better schools. All else being equal, paying one point with a $100,000 annual income would let you borrow an additional $7,875 in our example.

Paying points on an ARM

Paying points with an adjustable-rate mortgage (ARM) doesn't just lower your rate. It also gives you some protection against higher rates in the future. That's because an ARM's rate caps are based on the original rate. That protection only lasts as long as you keep your loan.

"If you're paying points for a lower rate, you're going to want to enjoy that rate for a long time to reap the benefits," says Andrew S. Weinberg, principal at Silver Fin Capital Group, a mortgage company in Great Neck, N.Y.

Income tax implications for paying points

Points that you pay to get a lower rate may be deductible on your federal tax return, but there are rules and limitations. If you're buying a home, you can deduct points in the tax year you obtained your mortgage. If you refinance, you can deduct points only over the lifetime of the loan.

Other rules, according to Mario Costanz, CEO of Happy Tax, a tax preparation service franchise company in New York:

• Your new mortgage must be taken out to buy, build or improve your primary home.

• Your points shouldn't cost more than the amount generally charged in your area.

• Your points can't be paid with borrowed funds.

The Tax Cuts & Jobs Act, enacted in 2018, changed some of the tax implications of paying points. The act capped the mortgage interest deduction, which could impact how you can apply your points, says Costanz. It also increased the standard deduction, which could reduce your incentive to itemize. To deduct points, you'll have to itemize and report the points on Schedule A of your tax return.

Each borrower's financial situation is unique, so the decision to pay or not pay points may come down to the cash reserves you have available when closing your mortgage loan.