When it comes to mortgage points, it pays to keep score.
Be warned, though: It can get tricky. The term points has multiple meanings in the mortgage world.
Mortgage points can refer to loan origination fees (fees charged by the underwriter) or discount points (also known as loan discounts). The worksheet above focuses on discount points, which represent 1% of the total loan amount. By paying a discount point, you can lower your interest rate. Consider it prepaid interest.
In general, you can knock off about 1/4 to 1/8 of a percent off your interest rate for each point you pay, says Keith Gumbinger, vice president of mortgage information provider HSH Associates. And because these points are interest payments, they're usually tax-deductible. A notable exception to that rule, however, is refinanced mortgages. In this case, only a few states allow you to deduct discount points (North Dakota, South Dakota, Nebraska, Minnesota, Iowa, Missouri and Arkansas) and even then, it's restricted to certain circumstances. You may also be able to deduct a portion of your points if you refinance your mortgage to raise money for home improvements regardless of which state you call home.
Generally speaking, it takes about five to seven years to recoup the cost of paying a point upfront. Here's the math. Let's say you take out a $100,000 30-year fixed mortgage, and you have the option of either paying 6% with no points or 5 3/4% with one point. With the 6% mortgage, your monthly payment will be $600. And with the 5 3/4% loan, it would be $584, a savings of $16 per month. After about 62 months, or a little over five years, you would have recouped the $1,000 point you paid upfront. And then you would start to benefit from the lower monthly payments.
But you must also consider how you might otherwise invest that $1,000. If you can beat the taxable equivalent of your mortgage rate (about 8% in the example above for those in the 25% tax bracket) then don't bother paying points. Invest the money instead. As you'll see from the worksheet above, however, we believe 6% is a prudent estimate for long-term returns.