A Pointed Look at Points, Points and Points

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When it comes to a mortgage, aside from being 1 percent of the loan amount, the term point also can refer to either prepaid interest or fees for loan-related services or both. Duncan explains the most common meaning of point–often referred to as one discount point--" is simply prepaid interest. If a lender can receive part of the interest payment upfront, he or she will often lower the interest on the rest of the debt." Most lenders will gladly trade pre-paid interest in return for a lower rate because no one really knows how long the loan will actually last. Will the buyer sell the home or refinance it in one year? In five? Few mortgages last the full 30-year term of the loan.

" Let's say you took out a $100,000 mortgage today with no points at 5.75 percent for 30 years," Duncan says. " If you are willing to pay one point of prepaid interest--$1,000 up front--the lender will lower the interest rate because you have increased the certainty of getting a return on investment—a profit."

However, this is not the only way the term point is used, Duncan adds. " Sometimes lenders will characterize other expenses in the same way, as a percentage of the loan." So instead of putting an actual price tag on costs such as origination fees, document preparation charges, and all the other expenses involved in getting the money, lenders often express them in terms of points.

Instead of setting a fixed price, the lender gives the charges a value that is a percentage of the total borrowed, charging you two points, three points, three-and-a-half points or even more to get the loan. The amount of paperwork doesn't change, and neither does the time spent working on the deal, but some lenders make sure the costs match the size of the loan. It is important to remember that these points have nothing to do with return on investment. They are just a convenient way for the lender to charge for the time spent drawing up the papers.

The various uses of points are the most confusing aspects of getting a mortgage. " If you talk to three different lenders about what the interest rate will be and what the loan will cost," Duncan says, " you will get three different amounts and three different uses of the word points.

" This is why it is so important to talk to more than one lender, and to tell each lender what the others are offering." Tell the lender what interest rates the other lenders are charging, the points in terms of prepaid interest, and how much the points or flat-rate charges to process the loan will cost. " The number one consumer protection is shopping," Duncan says. " There are no foolproof methods but comparison shopping is the best one going."

He explains that another reason to know which points are prepaid interest and which are associated loan costs is because prepaid interest is tax deductible, while loan-associated costs are not. Since mortgage interest payments are the single largest income tax deductions the average homeowner will ever have, it is important to know what is deductible. Deduct too many points, and the IRS could be calling on you. Deduct too few, and you are throwing money away.

" From the consumer's perspective," Duncan says, " when you buy a house, the interest-related points are a deduction in the year the points are paid. On a refinance, however, the points you pay are deductible over the expected life of the loan, not all in one year." So if you take out a 30-year, $100,000 loan to purchase and pay one prepaid interest point, you can deduct the full $1,000 that year. If you take out a 30-year, $100,000 refinance loan for one prepaid-interest point, you would be able to deduct 1/30th of that $1,000 on your taxes every year--$33.33. Duncan adds that some of the points associated with getting a loan may also be deducted from your taxes, depending upon the exact nature of the expense, your own personal circumstances and where you live. Check with your tax preparer.

Buying a home is a major and complex financial arrangement, and you should make sure you understand all the details of the process--each and every point. The last thing you want to do when you make the largest single investment of your life is miss the points.