- What are Mortgage Points?
- How do Mortgage Points work?
- How much do Mortgage Points cost?
- What is a “Breakeven Point” and why is it important?
- “I spent $8,000 and am only saving $114?”
- Advantages of Mortgage Points
- Disadvantages of Mortgage Points
- When to Buy Mortgage Points…
- When NOT to buy Mortgage Points…
- Mortgage Points FAQs
- The Bottom Line: Are Mortgage Points Worth It?
There aren’t many things that can affect your financial decisions the way an interest rate can.
Interest rates have long been the measuring stick for how well an economy is doing.
The slightest changes in rates create a ripple effect on the banking, investment, and real estate markets.
Interest rates are the smallest numerals you see on a loan proposal, but they have the largest impact on the contract.
They are a primary driver in how much a home really costs you and can affect a borrower’s purchasing decisions.
The good news is that you can alter the interest rate presented to you in a mortgage proposal regardless of economic conditions or even your credit score.
If you are considering a new home, but the mortgage payment is a little higher than you want, you can consider using mortgage points to lower your rate.
They’ll save you a little each month — and thousands by the end of the mortgage term.
Let’s take a deeper look at mortgage points and how they work.
What are Mortgage Points?
Mortgage points are optional fees you can pay at closing in exchange for a lower interest rate.
They are often referred to as “discount points”, and the act of using mortgage points is sometimes called “buying down the rate”.
If you elect to purchase mortgage points, you are essentially paying a small portion of your mortgage interest upfront in exchange for a lower interest rate.
How do Mortgage Points work?
Let’s assume the bank offers you a 4% interest rate on your $400,000 mortgage for a 30-year term.
The monthly payment is $1,910, and that’s a little more than you want.
One mortgage point is typically equivalent to a 0.25% reduction in the interest rate.
You can lower your rate to 3.5% by purchasing two mortgage points.
Your mortgage payment is now $1,796 per month with this lower rate.
How much do Mortgage Points cost?
One mortgage point costs about 1% of your total loan amount.
That means it costs $4,000 for each of the mortgage points we purchased in our $400,000 mortgage example.
Our investment in two mortgage points costs $8,000, and we lowered our monthly payment by $114.
What is a “Breakeven Point” and why is it important?
A breakeven point is the time it takes to recover the money you spent buying the mortgage points.
It is essential to determine how long it will take to regain your costs so you know if the additional fees are a good investment.
We spent $8,000 to save $114 per month in our example.
If we divide $8,000 by $114, we see that it will take a little over seventy months to break even with our investment.
If you plan to live in the home for six years or more, and you bought the points without draining your savings, then for now this is a good investment.
But we still have other factors to consider, so read on.
“I spent $8,000 and am only saving $114?”
The original term of our $400,000 mortgage offered a 4% interest rate.
Our monthly payment was $1,910 for thirty years.
By the end of this mortgage, you will have paid a total of $687,600, and $287,600 of this is interest.
The bank will lower our rate to 3.5% if we buy two mortgage points.
This changes our monthly payment to $1,796.
In thirty years, you will pay a total of $646,560.
The total interest paid in this case is $246,560 – a difference of $41,040.
If all payments are made on time and for the duration of the loan term, you can see that the $8,000 investment on the front end saves $41,040 in interest charges.
Short term speaking, the $114 savings is almost insignificant compared to a roughly $2,000 mortgage payment.
However, there are substantial savings over the loan term.
Advantages of Mortgage Points
A better interest rate is the primary advantage to buying mortgage points:
- You get a lower interest rate regardless of your credit score
- This lower interest rate results in a lower monthly payment, which may help you afford your home more comfortably or scale up to one of higher value
- The lower interest continues to pay dividends for you throughout the life of the loan. The modest savings you receive each month snowballs into greater wealth by the end of the loan
Disadvantages of Mortgage Points
There are some disadvantages with mortgage points to keep in mind. These include:
- Buying mortgage points can be expensive and increases your closing cost by the points’ value
- Because it’s long term focused, it takes years to see a return on your points-buying investment
- By investing in mortgage points instead of a larger down payment, the lender may require private mortgage insurance (PMI)
- If you sell your home before you reach the breakeven point, you will lose your mortgage points investment
When to Buy Mortgage Points…
If you have the extra money, it can be a good idea to buy mortgage points IF:
- You plan on keeping the house and the mortgage at least through the breakeven point
- Lowering the monthly payment helps you live more comfortably
- Buying points is a better return on investment than applying that money to the down payment
- You are, preferably, using a fixed-rate loan
When NOT to buy Mortgage Points…
The advantages to buying mortgage points are clearly the savings from the lower interest rate.
But in the following cases, it isn’t a wise investment:
- You are using an adjustable-rate loan – the rate will change several times before you cross the breakeven point, jeopardizing your investment
- Using your available cash hurts your emergency fund
- It’s a better investment to apply that money to the down payment
- You plan to sell, refinance, or pay the loan off before the breakeven point
Mortgage Points FAQs
Next, we’ll take a look at some of the most commonly asked questions associated with mortgage points.
Q. How do mortgage points work with ARM loans?
Mortgage points work with adjustable-rate mortgages (ARMs) the same as they do with fixed-rate loans.
However, an ARM’s structure is reset periodically with a new interest rate and balance.
The interest rate can fluctuate up or down depending on the economy and other variables.
If you plan to buy points with an ARM, it’s crucial to understand the loan structure and the feasibility of buying points with these types of loans.
Q. Are mortgage points tax-deductible?
Mortgage interest is tax-deductible if you file itemized deductions, and mortgage points are prepaid taxes.
For some people, this is another advantage to buying mortgage points.
Please consult with your tax preparer to see if it benefits you.
Q. Are mortgage points and mortgage origination points the same?
Mortgage origination points cost similarly to mortgage discount points at 1% of the total mortgage, but that’s all they have in common.
Mortgage origination points are the fees charged by the lender to provide your loan.
Mortgage points are optional fees you can pay to lower your interest rate.
On the other hand, mortgage origination points are not optional.
The Bottom Line: Are Mortgage Points Worth It?
Buying mortgage points can be a worthwhile investment in the right situation as shown in our $400,000 mortgage example.
However, that was just an example, and you must evaluate the data specific to your situation.
While some borrowers will benefit from buying mortgage points, others will not.
It’s important to review all the factors associated with your loan:
- interest rate
- points options
- down payment
- loan terms
- available cash on hand
Realizing your long-term plans for keeping the home are also important.
Finally, determine the course of action that works best for you, and using this information as your guide, go for it!