In general, points are an optional add-on expense you can use to reduce the interest rate on your new mortgage. Each point is equivalent to one percent of the total mortgage amount. When you choose to pay, each point will reduce your interest rate, typically by one-quarter of a percent, or .25%.
As always, figuring out whether or not to pay these additional fees comes down to your longer-term plans, and how long you can safely wait to break even on your refinancing. Paying points essentially amounts to paying interest upfront.
So, who benefits from points? Ideally, everyone.
Your lender gets to collect this fee immediately, rather than waiting for the interest to trickle in with each monthly payment you make on your mortgage. Yes, that means losing out on the full power of compounding interest at the starting rate, but it also mitigates against the risk of you defaulting or paying off the loan earlier. That can be an attractive prospect for lenders, so it is pretty typical for points to be offered as part of a refinancing package.
As a borrower, you get to cut down the total amount of interest you pay by slowing the rate at which it grows. Every point trims a little bit off the total rate, increasing your initial expenses but magnifying your total savings over time. In a sense, this is a win-win--but only if it is affordable for you to pay more money at the point of origination. You, like your lender, may very well prefer to have money today, rather than the promise of more money tomorrow.
The Trade-Offs: Timing is Everything
Remember, the more you pay upfront to refinance your mortgage, the longer it will take you to start enjoying the savings. Although paying points can save you even more than a standard refinance in the long run, it can quickly increase your initial costs, and push your break-even point further into the future. Every point you consider paying will require you to recalculate your break-even date again.
That is why generally, it is only advisable to pay points at closing when you are confident you will be staying in your home long enough to pass that break-even date and actually enjoy the full savings on interest. If you aren’t confident that you will stay in your home that long, you can still refinance without paying points, and enjoy savings that better fit your personal schedule.
Of course, you must also be financially prepared to pay a larger fee in the first place. Points do nothing to reduce the normal closing fees associated with refinancing. They are optional, one-time fees you can include at your own discretion. Although it may suit you to have a lower monthly payment, and significantly less total interest over the life of your new loan, the upfront cost of adding each point can quickly inflate the expense of refinancing. It pays to carefully consider your own timeline and goals, both financial and personal.
While it is possible to pay points on a new Adjustable Rate Mortgage (ARM), the reduced interest rate will still be subject to change eventually (depending on the terms of the loan), and fluctuations in market rates can effectively reduce or eliminate the long-term benefit to your total interest costs. The only way to guarantee you enjoy the savings that come from paying points is on a Fixed Rate Mortgage. Of course, if you are refinancing to switch from an ARM to a fixed-rate plan, then you don’t have to worry about this.
Paying points is a way for you to enhance the opportunity to save money that refinancing creates. However, like every aspect of refinancing, it requires you to plan ahead, define your goals and your timeline, for you to take full advantage of the option. Plenty of people manage to save and successfully refinance without points, but others are able to absorb the added cost and enjoy even lower interest rates. As long as you account for points in calculating your own break-even date and can plan around that, you can determine whether they are worthwhile for you.