How do loan points work?

I see loans with no points. What's the catch? How do loans with points work? What does it mean?

2 Answers

Basically, points are just prepaid interest on your loan. By paying larger upfront costs, you, in theory, receive a lower interest rate. The key is to look at the payback period.....for instance, if you spend $2000 in points and save $40/mn versus the loan with no points, the payback is 50 months. If there is any chance you will be in the home less than 50 months, probably not a great option. If your payback happened to be 40 months, and you plan to live in the house for many years, might be a better option. There is no direct correlation between points and interest rate reduction, for instance a 1% origination fee might mean a .25% rate reduction on one day, and only .125% on another, same thing applies from lender to lender.

Points are a way to "buy-down" your mortgage rate and create a lower monthly payment for yourself. Each borrower has to determine if paying the upfront points makes sense; however, think about this, you will be paying these points in TODAY'S DOLLARS, so even though you are lowering your monthly payments by paying the points, you are lowering payments that will be make with FUTURE DOLLARS, does this really make sense? Even today with very low inflation, future dollars are worth less than today's dollars. Also, remember you are getting a secured loan (mortgage) some of the cheapest money around, so if you pay points you are in effect "investing" those dollars in reducing secured (cheap) debt...you could invest those dollars elsewhere for a MUCH better return!