What are points?
Points are up-front mortgage interest fees paid on a loan to reduce the initial interest rate. For example, a one point loan will always have a lower interest rate than a zero point loan. Therefore, paying points is a trade off between paying money now versus paying money later.
When You Should Pay Points
Generally, you should only pay points if you plan on keeping the loan for at least four years. Because points are prepaid interest, you need to be sure you will keep the loan long enough to recoup these costs through lower monthly mortgage payments. If there is a chance you may move within a four year period or if the general interest rate market is declining (increasing the likelihood of refinancing), you should consider a no points or cash back loan.
The tax treatment of points depends on what the loan is being used for. If you are purchasing a home, points are generally entirely deductible in the year you buy. This is true even if the seller is paying for your points.
In a refinance transaction, points must be amortized over the life of the loan. For example, on a 30 year loan, you can deduct 1/30th of the points paid each year. If you refinance for a second time, however, you can deduct the remaining unamortized points in the year you refinance the loan. Consult your tax advisor for more information.
Effect on APR
A common though not necessarily relevant way to measure loan costs is the annual percentage rate or APR. The APR shows points and costs as an interest rate equivalent spread over the life of the loan. As shown in the figure below, fixed rate loans are more sensitive to changes in points than adjustables.