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Should You Pay the Points or Choose a Higher Interest Rate?

  • January 28, 2015

It’s decision time: should you pay higher points or choose a higher interest rate on your new mortgage? The answer is, “it depends.” Let’s take a deeper look by answering some of the most common questions:
What are points?
A “point” is one-percent of the amount you’re going to borrow. So if you borrow $250,000, one point equals $2,500. Basically, a point is prepaid interest that is included in your mortgage closing costs. Generally, the more points you pay upfront, the lower your interest rate will be.
How do points lower interest rates?
Because they’re prepaid interest, points reduce the interest rate you’ll pay over the life of the loan. A rule-of-thumb is that paying one point will reduce your interest rate by one-quarter percent. So if you paid two points, your rate would drop by one-half percent.
Are points tax-deductible?
Depending on your tax situation, points are deductible (again, because they’re prepaid interest). You’ll want to ask your tax advisor to be sure. For a new mortgage, your points may be deductible in the year you pay them. If you’re refinancing, points are generally financed along with the loan amount. In that case, points are generally deducted over the life of the mortgage.
Should you choose higher points or a higher rate?
That depends on how you answer two key questions:
1. Can you afford to pay them? Remember, for a new home purchase you’ll have to pay the points in cash at closing. Do you have enough cash on hand to comfortably pay the points, as well as your down payment and other closing costs?
2. How long do you plan to live in your new home? If you plan on moving again in just a year or two, it may make sense to avoid paying points and take the higher interest rate. But if you’ll be staying in your new home for several years, paying the points may be the better idea. By doing so, you’ll have the benefit of a lower interest rate over the life of the loan, which could substantially lower the total cost of your mortgage.

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