Pay Points on a Mortgage If You Expect to Prepay?

April 19, 2004 "I was planning to pay 1 point to reduce the rate on a new 30-year FRM from 4.125% to 3.75%. I expect to be in the house about 7 years. Using your calculator, I get a break-even of 34 months. However, I expect to add substantially to my monthly payment in order to pay down this loan faster. Will this affect my break-even?" Yes, it will lengthen the period before you break even � meaning that paying the point is not quite as good an investment. Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, 1 point means a payment of $1,000. The more points a borrower pays, the lower the interest rate. The benefit from paying points consists of the saving in monthly payment resulting from the lower interest rate, plus the lower loan balance in the month the loan is paid in full. The longer the borrower holds the mortgage, the greater the benefit. On a 30-year loan paid off after 7 years with no extra payments, the return on investment is about 24%. If you make extra payments during the 7 years, equal to the difference in payment between a 30-year and a 15-year loan, the return drops to 20%. These returns were derived from calculator 11c on my web site. So prepayments reduce the return on investment, but not so much that you should reconsider your plan to buy down the interest rate. 20% is an excellent return, especially in today�s market! Copyright Jack Guttentag

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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