Mortgage Points Explained: What They Are & How They Work
Key Takeaways
- If a line for mortgage points has turned up on your loan estimate, the question is less about the rate than about the cash you have available, since the down payment and closing costs have a claim on that cash before points do. Crunch the numbers if you are on the fence between putting 20% down and buying points, because a lower down payment may leave you carrying private mortgage insurance, an added cost that could offset the interest savings earned from purchasing points.
- No point comes with a set amount of rate reduction, because the lender and the marketplace determine the reduction you receive when you purchase points, which is why the discount is never fixed. On an adjustable-rate mortgage that discount usually reaches only the initial fixed-rate period, so the question becomes whether you recoup the cost before that period expires, and buying down the rate makes the most sense on a fixed rate mortgage when you plan to own the home past your break-even point.
- Think of the cash as money put in a bank to make interest, since how long you wait for the return is a factor, and typically most financial advisors would say that if you cannot break even in 36 months or less then it will not make sense, on the reasoning that those same funds may have made more money in a different investment vehicle. Paying points is probably not a good move if you plan to move or refinance in a couple of years.
- One percent of your total home loan amount buys a point, or $1,000 for every $100,000 borrowed, and that charge comes on top of the origination fee rather than replacing it, since points and origination fees are not the same thing. Divide the cost of the points by the monthly payment saving and the result is the months needed to recoup the cost: take $6,000 against $87.81 a month and it comes to 68 months, with a sale before then leaving you no money saved.
A common question for home buyers, especially first-time buyers, when they first see a loan estimate (LE), is about mortgage points. Unless you’re familiar with the mortgage industry, you probably aren’t aware of how mortgage “points” work or if they might make sense for your situation. Because your interest rate is impacted by the points included (or not) on your mortgage, it’s important to know the basics of what they are and how they work to fully understand the pros and cons.
What are mortgage points?
Also commonly known as “discount points” or “buying down the rate”, mortgage points are upfront fees paid directly to the lender at closing in return for a lower interest rate. Essentially, you pay a little more upfront to lower your monthly payment and potentially save thousands in interest over the life of the loan. One “point” equals 1% of the total amount of your home loan (or more simply $1,000 for every $100,000 borrowed).
Simple, right?
But the question is why does this make sense? More importantly, does it make sense for your situation?
Calculating your break-even point
For the most part, the longer you plan to own your home, the more points you buy down now, the more you would save in interest payments from paying less monthly over the life of the loan.
Since buying down your rate is an upfront and additional cost, it’s important to consider your break-even point (how long it will take to recoup the cost). There must be an ideal point in time at which your overall savings becomes MORE than the additional cost of paying points for a lower interest rate otherwise it just doesn’t make sense financially.
To calculate the break-even point, divide the cost of the points by how much you save on your monthly mortgage payment. The result will determine how long it takes for the interest savings to equal the cost of the mortgage points used.
Let’s use a quick example to explain how this might work:
- Let’s say your points cost $6,000
- You save $87.81 in monthly mortgage payments
- Divide the $6,000 of paid mortgage points by the $87.81 in monthly savings which equals 68 months to recoup your initial investment.
What you must now determine is the time you expect to remain in the home for you to at least reach the break-even point. If you decide to sell your home before your break-even point of 5 years and 6 months (68 months), then you would not have saved money by buying mortgage points when you took out the loan.
When is it worth it to buy points?
Typically, most financial advisors would say that if you can’t break even in 36 months or less then it won’t make sense.
If you're planning to move or refinance in a couple of years, paying points is probably not a good move.
Think of it as if you’re putting money in a bank to make interest. The longer you have to wait to get the return is also a factor. Waiting longer than 36 months in most cases means that you may have been able to put those same funds in a different investment vehicle and make more money than what the cost would’ve saved you.
Key facts about mortgage points
The terms around buying mortgage points can vary significantly from lender to lender so consider the following carefully.
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The lender and marketplace determine the interest rate reduction you receive for purchasing points so it’s never fixed.
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Mortgage points and origination fees are not the same things. Mortgage or discount points are fees paid in addition to origination fees.
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You can potentially receive a tax benefit from purchasing mortgage points. Make sure to contact a tax professional to learn how buying points could affect your tax situation.
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Mortgage points for adjustable-rate mortgages (ARMs) usually provide a discount on the loan’s interest rate only during the initial fixed-rate period. Calculate the break-even point to determine if you can recoup what you paid for in points before the fixed-rate period expires.
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Crunch the numbers if you’re on the fence on whether to put a 20% down payment or buying mortgage points. If you choose to make a lower down payment, you may be required to carry private mortgage insurance (PMI) so factor this additional cost because it could offset the interest savings earned from purchasing points.
Mortgage points FAQs
How much does one point lower your rate? The lender and marketplace determine the interest rate reduction you receive for purchasing points, so it's never fixed. Your loan estimate (LE) will show the exact rate-for-points tradeoff offered on your loan.
Are mortgage points tax deductible? You can potentially receive a tax benefit from purchasing mortgage points. Make sure to contact a tax professional to learn how buying points could affect your tax situation.
When do you pay for mortgage points? Mortgage points are upfront fees paid directly to the lender at closing. One point equals 1% of the total amount of your home loan, or more simply $1,000 for every $100,000 borrowed.
Does it make sense for you?
To determine whether mortgage points are right for you, you need to find out how much you have available for the home buying process: down payment, closing costs, monthly mortgage payments, and mortgage points.
Use our mortgage calculators to help you work out how much cash you need to close.
Buying points to lower your interest rate makes the most sense if you select a fixed rate mortgage and you plan on owning your home after you’ve reached a break-even point of 36 months or less.
Under the right conditions, purchasing points when you purchase a home can save you quite a bit of money over the full length of your loan term. Remember, there’s a lot to think about when considering “paying”/“buying” points to lower your rate. To be absolutely sure you’re making the right decision, contact one of the mortgage experts at American Financing if you’re considering buying a home and leveraging mortgage points.
