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People often get confused over the issue of paying points on mortgages when in fact it is a fairly simple decision. Many people also believe incorrectly that zero point mortgages are best because you don't have to pay anything up front. What they are missing is that the rate that they are being charged on their mortgage is higher because of the lack of points. For a fixed rate mortgage, there are only a few factors that you need to make the decision: length of time expected to be in the home, interest rate, and the points.
Honestly, if any of you are thinking of buying a house and staying in it for less than 5 years, don't buy the house because you will end up with a much bigger problem than not getting the value of your points.
The simple rule is that if the difference in points divided by the difference in your interest rates is 3 or less, pay the points. What this means is that for ever dollar you pay in points it will take you 3 or fewer years to get your money back. Not a bad deal considering that you may hold the loan for 30 years! So for instance, let's say that you have a loan with a 5% interest rate and zero points or one with 4.5% and 1 point. The difference in interest rates is 0.5% and the difference in points is 1% giving you a ratio of 2. After 2 years, you will have broken even on your "investment" and after that, you are saving money. Each year you are saving 0.5%, so it takes two years. Lenders reward you for putting more money upfront because it lowers the probability that you will refinance the loan. Another benefit of points is their tax deductibility when you buy the home, a time when you need as many breaks as possible.
When might you pay more? If you are able to get a very, very low interest rate that you are almost certain you will never refinance and you really have your dream house. At that point, you might even go out to a break-even of 5 years. Realistically, let's assume that you could get a 4% interest rate on your dream house. What is the probability that you would ever get to refinance that? Likely pretty low since you would need to see a rate of 3.5% or less for it to make any sense and you would likely need to pay points.
When might you pay no points even with a ratio of 3? First, if you have no extra cash, it is pretty simple. Also, if the loan you have has a very high interest rate that you are likely to refinance in the near future. But be careful before you ever agree to a high rate. Declining property values make refinancing very difficult. If your rate is too high, you might just skip the purchase altogether until you can get your finances in order to get the best rates.
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