# Points

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## Point

## Points.

The term points can mean different things in different contexts.

With regard to stock, a point represents a $1 change in market price, so if a share of stock rises two points, its price has risen $2. With bonds, a point is a 1% change above or below its par, or face, value, so if a bond has a par value of $1,000, a point equals $10.

But in the case of futures and options, a point usually represents a price change of one-hundredth of one cent. And you may also hear about points if you're applying for a mortgage.

In this case, points -- also called discount points -- are prepaid interest some lenders require at closing as a condition of approving the loan. One point is 1% of the mortgage principal, or 100 basis points. So if you are borrowing $200,000 and your lender charges 2 points, you owe $4,000, in addition to other closing costs.

Prepaid interest is tax deductible in most cases, and your long-term interest rate will be lowered slightly -- often 0.25% or 25 basis points -- for each point you pay. But because points increase your closing costs, you may decide to choose a lender that doesn't require points if you plan to move or refinance within a few years.

## points

Charges in connection with a mortgage, calculated with reference to the amount of the loan.One point is equal to one percent of the loan. A fee of three points on a $100,000 loan is $3,000.

• See *discount points* for an explanation of the use of this device to reduce the interest rate on a loan.

• Origination points are the same as *origination fees*, and are charges to cover lender or mortgage broker expenses and profit.

## Points

*An upfront cash payment required by the lender as part of the charge for the loan, expressed as a percent of the loan amount; e.g.,“3 points”means a charge equal to 3% of the loan amount.*

When points are negative, the lender credits the borrower or the mortgage broker. Negative points are termed “rebates.” When retained by a mortgage broker, they are termed “yield spread premiums.”

** Points and Rebates as Borrower Options:**The points/rebate system is unique to the U.S. It offers borrowers more options at the cost of greater complexity. The following is a typical schedule for a 30-year fixed rate mortgage.

5.375% and 2.75 points

5.50% and 2.0 points

5.625% and 1.375 points

5.750% and 0.75 points

5.875% and 0.125 points 6% and 0.5 rebate

6.125% and 1.0 rebate

6.25% and 1.5 rebate

6.375% and 2.0 rebate

6.5% and 2.3755 rebate

For borrowers who have the cash and expect to remain in their house for a long time, paying points to reduce the rate makes economic sense. The benefit from the lower rate extends over a long period. In addition, borrowers who have difficulty qualifying because their income is low relative to their monthly housing expense may pay points to reduce their monthly payment.

In contrast, borrowers with a short time horizon do better with high-rate/rebate combinations because they don't pay the high rate very long. In addition, borrowers who are cash-short prefer to pay interest rates high enough to command rebates, which can be used to cover their settlement costs.

** Sharpening the Rate/Point Decision:** Borrowers who are neither cash-short nor income-short can sharpen the decision process using one of the calculators on my Web site. Calculators 11a and 11b, covering FRMs and ARMs, respectively, compare the future costs of a low-rate/high-points combination with those of a high-rate/low-points combination over any period specified by you. These calculators also show the “break-even period,” which is the minimum period you must hold the mortgage to come out ahead with the low-rate/high-points combination.

A different approach to the decision is to look at the payment of points as an investment that yields a return that increases the longer you stay in your house. This return can be compared to the return on other investments available to you. This approach is used in calculators 11c and 11d.

** Paying Points Versus Making a Larger Down Payment:** An advantage of viewing the payment of points as an investment decision is that it allows you to compare the return from paying points with the return from increasing the down payment. (You can find the latter using calculator 12a.)

In both cases, the borrower makes an upfront cash outlay and receives a stream of income in the future. With a larger down payment, the income is the reduction in monthly payment that results from the smaller loan and mortgage insurance premium. With points, the income is the reduction in monthly payment that results from the lower interest rate. The better investment is the one that yields the higher return over the period you retain the mortgage.

The return on investment in points is extremely sensitive to how long you stay in the home. For example, if you are in the 25.5% tax bracket, pay four points to reduce the rate on a 30-year fixed-rate mortgage from 6% to 5%, and stay in your house for three years, your after-tax return is a negative 12.6%. But if you stay for 15 years your return is a positive 16.4%.

In contrast, the return on an investment in a larger down payment declines over time, though not very much. If you increase your down payment from 5% of the property value to 10%, for example, which reduces the mortgage insurance premium on a 6% 30-year FRM from .78% to .52% of the loan amount, the after-tax return over three years is 10.0%; over 15 years it is 8.8%.

Hence, if your time horizon is short, you should invest in a larger down payment, and if it is long, you should invest in higher points. But how long is “long”?

In most cases the crossover point where the returns are the same occurs in eight years or less. However, the crossover point is affected by a number of factors, including your tax bracket, PMI premiums, the rate reduction you receive for a given increase in points, and appreciation of your house, which affects how long you'll carry PMI. The beauty of calculators 11c, 11d, and 12a is that you can take account of all the specifics of your own particular situation.

** Financing Points:** Points can be included in the loan amount, but usually it isn't a good idea if you can avoid it. The break-even periods are usually longer, as illustrated in the table. The first number in each cell assumes the borrower pays the points in cash while the number in parentheses assumes the points are financed.

Financing points lengthens the break-even period if the savings rate—the rate the borrower could earn on cash not used to pay

points—is below the rate on the high-rate/low-points mortgage. This usually is the case. On purchase transactions, furthermore, financing points spreads the tax deduction over time, whereas points paid in cash are deductible in the year paid. Financing points is worthwhile only where the savings rate is above the mortgage rate and the tax rate is low.

The break-even periods shown in the table on the previous page assume that financing the points does not raise any other costs to the borrower. Borrowers should be wary of the following exceptions.

First, the increase in the loan amount might bring it from an amount below to an amount above the maximum size loan eligible for purchase by the two government-sponsored entities, Fannie Mae and Freddie Mac. In 2003, the maximum was $322,700. Rates are higher on loans exceeding the maximum.

Second, the increase in the loan amount might bring it into a higher mortgage insurance premium category. Mortgage insurance premiums are based on the ratio of loan amount to property value, with three premium categories: 80-85% (the lowest), 85-90%, and 90-95%.

If the larger loan that results from financing the points triggers an increase in the interest rate or the mortgage insurance premium, there will be no break-even.