Small Business Taxes & Management^TM--Copyright 2014, A/N Group, Inc.

Points or No Points?

Before we can answer that question, we have to agree on the definition of points (also known as discount points). Technically, a point is equal to 1% of the amount of the loan and is similar to prepaid interest. It's not unusual for people to refer to many of the other charges associated with a loan as points, but that's not correct. The points are only associated with prepaid interest.

Paying points should reduce the interest rate on the loan. Generally, the reduction is 1/8 of 1% (or slightly more) for each point paid. For example, you can get a $200,000 loan at 4.75% and pay no points. If you pay 2 points, or $4,000 on a $200,000 loan, you can reduce the interest rate to 4.5%.

Often you won't have a choice from a single lender. Instead, you'll be comparing two different loans--bank 1 offers you a straight interest rate and no points; bank 2 offers a lower rate with 2 points. You can use the 1/8% per point rule above to compare the two loans. The rule of thumb works pretty well for 30-year mortgages, but the interest rate difference per point is larger on a 15-year mortgage. We've reproduced a table below showing the effective interest rates at various levels for 1, 2, 3, and 4 points on 30- and 15-year loans. Clearly, the larger the amount you're borrowing, the more you critical you want to be.

But that's all theoretical and assumes the mortgage will be outstanding for the full term. That is, you'll be paying on the loan for the full 30 years. According to one study, only slightly more than a quarter of the homeowners remain in their homes more than 20 years; about 50% stay at least 10 years. And it wasn't too long ago that refinancing a mortgage wasn't that common. But from 2009 to 2013 rates fell from some 5.3% to 3.3% creating a wave of refinancing. If you pay points up front to reduce your interest rate, the only way to recover your "investment" is if you hold out for the full term of the mortgage. Sell your home or refinance before the expiration of the term and the bank will have come out ahead.

Paying points up front to get a lower interest rate may make sense if you're going to be in the home and not refinance for the majority of the term of the mortgage. But even then you're laying out cash that many first-time homeowners need for early improvements. You will get some benefit from a tax deduction--points, if they qualify, are deductible in the year paid, if they're paid with the purchase of the home. If they're paid on a refinancing, they must be amortized over the term of the loan.

Under the IRS "safe harbor" points are deductible for income tax purposes if:

1. The amount paid as points is in connection with your residence,
   
2. The amount paid must be designated on the Uniform Settlement Statement as points or loan origination fees,
   
3. The points must be a percentage of the principal amount of the loan,
   
4. The charging of points must be an established business practice in your area for loans to acquire residences and the amount charged cannot exceed the amount generally charged in the area, and
   
5. You must pay the points directly from funds that have not been borrowed for this purpose and not add the amount to the principal amount of the loan.

There are some other requirements. And the safe harbor does not apply to a second home or a loan where the principal amount of the acquisition debt exceeds $1,000,000.

Effective Interest Per Point

The tables below show the effective interest rate based on 0, 1, 2, 3, and 4 points on 15-year and 30-year mortgages. For example, if the stated interest rate is 4.5% and you have to pay 2 points, the effective rate is 4.67% over the life of a 30-year loan. For a 15-year loan, the effective rate for a 4.5% mortgage with 2 points would be 4.8%.

    15-Year Loan

Stated Rate                       Effective Rate
                  1 point    2 points     3 points     4 points
3.75%              3.90%       4.05%        4.20%        4.35% 
4.00%              4.15%       4.30%        4.45%        4.61%
4.25%              4.40%       4.55%        4.71%        4.86%
4.50%              4.65%       4.80%        4.96%        5.12%
4.75%              4.90%       5.01%        5.21%        5.37%

Stated Rate                       Effective Rate
                  1 point    2 points     3 points     4 points
4.00%              4.08%       4.17%        4.25%        4.34%              
4.25%              4.33%       4.42%        4.51%        4.57%
4.50%              4.59%       4.67%        4.76%        4.85%
4.75%              4.84%       4.93%        5.02%        5.11%
5.00%              5.09%       5.18%        5.27%        5.36%

--Last Update 01/27/14