When shopping for a mortgage, you may have the option to pay more money up front in order to reduce the interest rate on your mortgage. This is known as paying 'points'. Each point represents 1% percent of the size of the loan, and paying one point should lower the interest rate on a loan 1/4%, 2 points should lower you rate 1/2% and 3 points should lower the rate 3/4%. Points can be a good option for those planning to live in the home for a long period of time, as the interest rate can be reduced significantly. For short-term buyers, however, points add to the closing costs and do not provide much benefit in the short run.

As a general rule, it takes approximately 5 years on a 30 year loan to recoup the cost of the points paid. If the drop in rate is less than 1/4% for each point paid, the amount of time it takes to recoup the points will be longer.

To calculate the break even point:

1. Calculate the Principal and Interest Payment on the Zero Point Loan (a)
2. Calculate the Principal and Interest Payment on the Point Loan (b)
3. Calculate the $ value of the Points (c)
4. Calculate a - b = the savings in your monthly payment (d)
5. Calculate number of years to recoup your points = ( d / c) / 12

For example:

You are purchasing (or refinancing) your home and borrowing $200,000. Your options are a 30 year loan at 7.00% with 0 points or 6.75% with 1 pt. To calculate your break even point:

1. Monthly principal and interest at 7.00% = $1,330 (a)
2. Monthly principal and interest at 6.75% = $1,297 (b)
3. Cost of points paid = $2,000 (1% of loan amount) (c)
4. Monthly Savings ($1,330 - $1,297) = $33 / month (d)
5. Calculate ($2,000 / $33) / 12 = 5.05 years to break even

There may also be some tax benefit to paying points. When buying a home, any points you pay are normally tax deductible in the year you pay them. This may shorten the break even point considering the savings on your monthly mortgage payment and tax benefit derived. However, it's always a good idea to speak to an accountant regarding tax benefits and paying points on a mortgage loan, as they will be able to advise you based on your particular tax status.