What are loan points?

Points are an upfront charge by the lender that is part of the price of a mortgage. Points are expressed as a percent of the loan amount, with three points being 3 percent. On a $100,000 loan, three points means a cash payment of $3,000. Points are part of the cost of credit to the borrower.

Points can be negative, in which case they are “rebates” from the lender to the borrower. Rebates can be used by borrowers to defray other settlement costs.

Low rates come with positive points; high rates come with rebates. Lenders offer borrowers a range of interest rate/point combinations, leaving it to borrowers to select the combinations best suited to their needs.

How should borrowers make this decision?

Low-rate/high-point loans are for borrowers who can meet the cash requirement, and either have a longtime horizon or want to reduce their monthly mortgage payment. High-rate/low-point combinations are for borrowers who don’t expect to be in their house very long, or who are short of cash.

Can points be financed?

Yes, but it reduces the benefit to the borrower unless the borrower is in a low tax bracket and can earn a high return on his cash. You should never finance points if it pushes the loan amount up to a level that triggers a larger mortgage insurance premium.

Are points tax-deductible?

On a purchase transaction, points paid in cash are fully deductible in the year the loan is closed. On a refinance, points paid in cash are deductible, but the deduction must be spread evenly over the term. If the loan is paid off, the unused portion can be taken in the payoff year. If points are financed, they are not deductible as points but they increase the interest deduction. Interest is deducted over the life of the loan, and if the loan is repaid early, the unused deduction is lost.

How many points must I pay to reduce the interest rate by 1/4 percent?

Starting with the base interest rate, which is the rate closest to zero points, expect to pay about 1.5 points on a 30-year fixed-rate mortgage. For example, if the lender quotes 6 percent at zero points and you want to reduce the rate to 5.75 percent, it will cost about 1.5 points. To reduce the rate by .375 percent, .5 percent or .625 percent, expect to pay about 2.125, 2.75 and 3.25 points, respectively.

Similarly, the following rate increases are required to produce the indicated rebates: .125 percent/.625 points; .25 percent/1.125 points; .375 percent/1.625 points; .5 percent/2.125 points; .625 percent/2.625 points; and .75 percent/3 points. For example, if you want a rebate of 2.125 points, expect to pay a rate about .5 percent higher.

On 15-year loans, all the points shown above would be about .375 points lower.

These numbers are averages based on recent price sheets of 10 lenders, and they are anything but firm. The amount of variability from lender to lender is surprisingly large. For example, while the average price to reduce the rate by .25 percent was about 1.5 points, two lenders charged only 1 point and one lender asked for 1.875 points. Similarly, while the average rebate obtainable for a .375 percent rate increase was about 1.625 points, one lender offered 2.112 points while another offered only 1 point.

How should points affect the way I shop for a mortgage?

Before you shop, decide what you want to do about points. If you want to pay points to reduce the rate, you shop rate based on a specified number of points. This has the added advantage of letting loan officers know that you know what you are doing.

If you want a rebate, the best strategy is to shop rate on a no-cost loan, which means a rebate high enough to cover all settlement costs except escrows and interim interest. This has the added advantage of protecting you against getting whacked with additional settlement costs at closing.

Selecting a loan provider while the rate/point combination is undecided is a bad mistake. Because of the wide variability in pricing points, the lender offering the lowest points at one rate is not necessarily the same as the lender offering the lowest points at a different rate.

Furthermore, once you are too far along in the process to back out, the price in points to lower the rate, or the price in rate to increase the rebate, may be “off the sheet.” Meaning that the loan officer may take advantage of the opportunity to make a few extra dollars by giving you a worse deal than the one shown on his price sheet.

Don’t let this happen to you.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.