What Are Points?
Technically speaking, a point is a device used to adjust the interest rate on a mortgage. It is expressed as the percentage of a loan amount. In other words, if a banker says you are paying 1 point on a $200,000 to get a 2.75% interest rate, the borrower would be paying an extra $2,000 at home closing. You can avoid paying this extra $2,000 in closing costs in exchange for a higher mortgage interest rate.
Why Do Points Exist?
Well, the answer is twofold. First, points give a lender an opportunity to lower their interest rate by paying extra cash at closing. Two, mortgage rates are quoted in 0.125% increments. It’s a vestige of how most publicly traded bonds rates are quoted. Even so, 0.125% is a big jump between two quoted rates. Points, positive or negative, help a lender to “round” their mortgage rate to the nearest 0.125%
What Are Positive Points? Negative Points?
Positive points are what we described so far above. It’s extra cash paid at closing (normally in the form of a closing cost credit) to attain a lower interest rate over the life of a mortgage. Negative points get you, the borrower, extra cash at closing in exchange for a higher interest rate.
When you are shopping around for mortgages, a loan officer might call this a “lender’s credit.”
Tax treatment of mortgage points, positive and negative, is beneficial to borrowers. First, the cash paid for positive points is tax deductible as an itemized deduction. Negative points, even though it’s cash in your pocket, is non-taxable. We can all thank lobbying by the National Association of Realtors in the 1980s for the preferential tax treatment of mortgage interest related expenses.
Since most articles are going to talk about when positive points make sense, we’re going to talk about when to request negative points from your lender.
When To Use Negative Points
#1: When You Aren’t Planning on Owning the Home for Long
The average duration of someone staying in a home is 10.5 years. This average is lower for the Sunbelt and higher in the Northeast. People who are younger tend to stay in their homes for shorter periods than older folks.
Negative points are often a good idea when planning on staying in a home for less than 10 years. There will always be a breakeven point between the extra money received at closing from negative points and additional interest paid from a higher interest rate. Let’s say your lender gives you a $3,000 credit in exchange for an extra $35 in monthly mortgage interest. In this case, your breakeven is 7.15 years (I’m simplifying this to make the math easier). If you were planning on own the home for a shorter time than that, negative points make sense.
#2: When You Can Invest The Cash Savings
In scenario #1, the $3,000 cash received with negative points is presumably spent elsewhere, leading to a breakeven of only 7.15 years. If we invested the $3,000 cash at 6% a year, our breakeven analysis is simple – we will always be better off taking negative points and investing the additional cash. Not only that, but because of compounding, the benefit of negative points will increase over time.
It’s important to note that if your investment earnings are lower, negative points seems less attractive. For instance, if your $3,000 only earned 3% a year, negative points would only make sense if you owned the house for less than 9.5 years.
#3: You Need Cash for Closing Costs
Finally, negative points are a must if you’re strapped for coming up with funds for your down payment and closing costs. Negative points are one of the easiest ways to have extra cash for closing costs, perhaps second to hiring a “rebate realtor.”
As mentioned before, negative points generally make sense. The only people who I recommend not use negative points are older individuals who do not have the risk capacity to invest in higher returning investments.