When shopping for a mortgage, some people focus on the interest rate and ignore everything else. However, they're missing a big factor that can affect how much they pay for their loan.
Mortgage points are used to adjust the interest rate and affect how much cash you need to close on your loan. In this article, we'll share what mortgage points are and how they can be useful when buying or refinancing your home.
What are mortgage points?
Mortgage points typically refer to discount points, which are a percentage of the loan amount paid directly to the lender to lower your interest rate. Points are prepaid interest that you pay in exchange for a reduced interest rate over the loan term.
You may also see the term “origination points.” This refers to different fees that a lender charges borrowers to process a mortgage, which are also based on the loan amount. Paying origination points doesn’t lower your interest rate.
How do mortgage discount points work?
Mortgage discount points reduce your interest rate based on how much you pay. The more interest you pay upfront in the form of mortgage points, the lower your interest rate will be.
One mortgage point equals 1% of your mortgage amount. On a $100,000 mortgage, one point would cost you $1,000. These points are paid at closing when your mortgage is finalized. This amount is included in the closing costs you pay, along with other mortgage costs, like title insurance, origination fees, and prepaid insurance and taxes.
For every mortgage discount point that you pay, you'll typically receive a 0.25% reduction in your interest rate for the life of the loan for a fixed-rate mortgage. If you opt for an adjustable-rate mortgage, the points may only apply during the introductory period. However, reductions on the interest rate vary by lender, so yours could be more or less. Points are listed on your loan estimate, so you know exactly how they affect your monthly mortgage payments.
Mortgage points are not always in whole numbers. Many times, they are fractions of a percent. Points are typically purchased in increments of 1/8th of a percent, or 0.125%. For example, you may pay 1.75 discount points on your loan to achieve the desired interest rate, which would most likely get you an interest rate reduction of 0.44%.
How much can you save with mortgage points?
A mortgage loan payment typically includes principal, interest, and escrow payments for homeowners insurance and property taxes. Monthly payments can be reduced by purchasing discount points, shopping around for your homeowners insurance, and taking steps to reduce property taxes.
While you can reduce your taxes and insurance at any time, the only time you can buy mortgage discount points is when you buy or refinance your home.
When a borrower buys mortgage points for their loan, they lower their monthly payments. Their monthly savings depends on the dollar size and term of the mortgage loan. In general, for every discount point you purchase, you'll save 0.25%, or 25 basis points, on your mortgage interest rate.
This home mortgage example shows how purchasing discount points can reduce the interest costs on your mortgage. The table below shows the difference in payments and interest on a 30-year, fixed-rate mortgage of $300,000. Remember that one point will typically cost 1% of your mortgage amount.
|No Points||Two Points|
|Minus cost of discount points||None||$6,000 (2 points at $3,000 each)|
In this loan scenario, the borrower paid $6,000 in discount points to save over $30,000 in interest over the life of their loan. By buying down their rate, the net savings is almost $25,000.
The best mortgage lenders will take time to explain your loan options and help you determine how many, if any, discount points you should pay on your mortgage.
Alternatives to buying discount points
Although you can save money on your mortgage by buying points, that isn't always the best financial move. If you have high-interest debt, using the money to accelerate the payoff of those balances could be a better choice. For people without consumer debt, maxing out your retirement accounts or putting the money into a brokerage account might yield higher returns.
For example, if you invested the $6,000 you would have spent on discount points at 6% for 30 years, you would earn over $28,000. While there are no guaranteed returns, the average historical returns of the S&P 500 have been 6.52%.
What are the benefits of mortgage points?
There are numerous reasons why you might consider purchasing discount points on your next home loan. These are some of the most common:
- Lower interest rate. For every discount point that you purchase, your interest rate will decrease.
- Possible tax benefits. Like the mortgage interest deduction, points may be deductible if you bought them to finance a primary residence. However, the IRS may not let you deduct all the points you paid in one year unless you meet certain conditions. Consult your tax advisor to discuss your personal scenario.
- Reduced monthly payment. With a lower rate, your monthly payment is also reduced. Buying discount points can help you increase how much mortgage you can afford by reducing your monthly payments.
- Total cost of your mortgage is reduced. Once you pass the breakeven point on your discount points, you're saving money on the total cost of your mortgage. The breakeven point is where the amount you saved by buying points equals the amount you paid for your points. For example, if you paid $6,000 for points, the point at which you’ve saved $6,000 by buying points would be your breakeven point. Purchasing points is a wise move for homeowners who plan to stay in their home for 6 to 10 years or more.
What are the drawbacks of using mortgage points?
While discount points have advantages, there are some drawbacks as well. These are the most common drawbacks for borrowers who purchase points:
- Higher upfront costs. Many homebuyers are already stretched thin financially when buying a home. Adding the cost of the points may be too much for them to afford, even if it makes financial sense.
- May not be worthwhile if you move. If you sell your home within a few years of purchasing points, you will have paid more than you've saved. Typically, you should plan to be in your home for 6 to 10 years to reach the breakeven point.
- Interest rates could go down. Many borrowers have refinanced their homes multiple times to take advantage of historically low interest rates over the last few years. If you purchased points on a current loan, it would be harder to justify refinancing if rates dip because you haven't broken even on the points yet.
- Opportunity cost of the money. While you can reduce your interest and save money by purchasing points, you might be better off investing the money or paying off other debt instead.
Who should use mortgage points?
Mortgage points can be a wise investment if you plan on staying in your home for a long period of time. The benefits are even higher if you can lock in an ultra-low mortgage rate since that reduces the possibility of a future refinance. Of course, qualifying for a low interest rate depends on your credit score, down payment, debt-to-income ratio, and other factors.
Purchasing discount points is best for home buying or refinancing when you have extra money available to cover the down payment, points, and other closing costs. For homebuyers or homeowners who are strapped financially, you may be better off keeping that money in savings. Having a lower mortgage payment doesn't help if you have to carry a balance on a credit card to pay for an unexpected expense.
One of the ways to tell if you should purchase points is to look at the breakeven point of each loan option that your lender presents you. A shorter timeframe is always better.
On our example of the $300,000 loan above, the 0.50% reduction in your interest rate would cost $6,000. Since you’re saving $85 per month, the breakeven point on this option is about 71 months, which is almost six years. If you stay in the home or keep the loan longer than six years, then you'll be making money by purchasing the mortgage discount points.
How much is 1 point worth on a mortgage?
One mortgage point is equal to 1% of your mortgage loan amount. On average, you should expect to see a 0.25% reduction in your interest rate for each point that you purchase. The savings can be substantial over the life of a mortgage loan if you hold the loan until maturity. In general, it takes 6 to 10 years to break even on purchasing a discount point.
How many points can you buy on a mortgage?
Theoretically, there is no limit to the number of points you can purchase to reduce your interest rate. In an extreme example, you could purchase your interest rate down to 0%. This scenario would allow you to prepay all of the interest you'd ever owe on your mortgage. In reality, however, most lenders will not allow you to more than four mortgage discount points on a loan.
What are basis points on a mortgage?
“Basis points” is a financial term that means one-hundredth of one percent. In the mortgage world, interest rates are often quoted in basis points, also called “bps” or "bips." A loan with a 2.50% interest rate would be referred to as 250 bips. Alternatively, if interest rates rise by 0.25%, a mortgage broker might say that the rate increased 25 bips.
When you’re learning how to get a loan, look at both the interest rate and the mortgage points quoted. While one lender may quote a lower interest rate, it may only be because they are charging more mortgage discount points to achieve that rate. The best option is to request quotes with no mortgage points in order to compare lenders on a level playing field.
Once you've chosen a lender, one of the questions to ask a mortgage lender is how your rate might change if you paid discount points. Most loan officers will share multiple scenarios of rates and points so you can find one that works best for your financial situation.
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