Mortgage rates are near historic lows these days, but there’s a way to make them even lower. It’s called buying points, essentially paying money upfront to the lender to get a better rate for the life of the loan. And while it sounds great on the surface, it may or may not be the best deal, depending on your circumstances.
In fact, the whole process can be confusing, which is why it’s crucial that you understand what mortgage points are and how to calculate whether this move can really save you money.
WHAT ARE MORTGAGE POINTS?
Your lender may offer you the option of paying points when you take out a mortgage on a house purchase or refinance an existing home loan. What you are doing is paying interest in the loan in advance. When you do so, you’ll be able to lock in a lower, discounted rate — the more points you purchase, the more you can save on your loan.
In most cases, one point gets you .25 percent off the mortgage rate and costs the borrower 1 percent of the total mortgage amount.
For example, if you buy a house and your mortgage is $200,000, one point would cost you $2,000. That would lower your mortgage rate by .25 percentage points, so a 4 percent mortgage would become a 3.75 percent one. It’s up to the lender to determine whether to offer borrowers the opportunity to purchase points, although most do allow this. And it’s up to you if you want to pay down the rate on your loan.
You’ll be able to see any points listed on your Loan Estimate, which is a document summarizing the key details of your loan offer. Points are also itemized on the Closing Disclosure, a form you get before settlement which provides the final mortgage terms. Mortgage points are paid at closing.
WHAT ARE DISCOUNT POINTS?
Discount points is another term for mortgage points. Points are actually prepaid interest on the mortgage loan. The more points you buy, the lower the interest rate on the loan.
Borrowers usually can buy as many points as they want up to the lender’s limit, depending on how much they want to reduce their rate. Every mortgage lender has its own price structure, so how much you can lower your rate by paying points depends on the lender, the type of loan and the mortgage market conditions at the time of closing.
WHAT ARE ORIGINATION POINTS?
Origination points cover the lender’s cost of processing the loan. They’re a way to pay closing costs – and they’re negotiable. The number of origination points lenders charge varies, so be sure to ask when you are shopping for a mortgage lender.
Lenders may use different terms for points such as “loan discounts.” Ask your lender for clarification if you’re unsure. Origination points do not lower the rate on your loan but they are a way to wrap closing costs into your loan without having to come up with the cash when the mortgage is issued. There’s no free lunch, however. You’ll have to pay interest on these costs over the life of the loan.
WHEN IS IT WORTH IT TO BUY POINTS?
Deciding whether to pay mortgage points depends largely on the amount of your down payment and how long you plan on staying in the home. Generally speaking, the longer you plan on staying put, the more likely your eventual interest savings will be greater than the upfront fee you paid to reduce your mortgage rate — and the more likely you will save on interest over the lifetime of your mortgage.
It’s important to consider how long it will take to recoup the cost of buying mortgage points — the so-called break-even point. This is how long it’ll take for the savings you receive from lower monthly payments to equal the amount you prepaid with points. (Bankrate’s mortgage loan points calculator can help determine your break-even.)
HOW THE MATH WORKS ON POINTS
Let’s say you took out a mortgage for $200,000 and purchasing one point at $2,000 saves you 0.25 percent in interest, reducing your mortgage rate to 4 percent from 4.25 percent. Instead of paying $983 a month, you’re now paying $954, saving you $29 a month. That means it’ll take nearly 69 months to break even, or 5.7 years. Over the life of the 30-year loan, you would save $10,502 in interest.
Keep in mind too that your $2,000 spent on the point could have been earning a return for you. Even at just 2 percent interest, that’s $40 a year, stretching your break-even longer.
“Buying down your interest rate through discount points is a financial decision that looks better the longer you own the home,” says Greg McBride, CFA, Bankrate’s chief financial analyst. “The upfront payment of points translates into a permanently lower monthly mortgage payment, so the longer you benefit from those lower payments, the better return on investment you get from paying points.”
Something else to consider before paying for points is your down payment. Make sure you do some calculations if you’re debating between buying points and making a higher down payment. One reason: If you put down less than 20 percent, you could be subject to paying private mortgage insurance (PMI), which can negate the benefit you’ll receive from buying points.
However, if you take out an adjustable-rate mortgage (ARM) loan, you may not be able to save enough money on points to make it worthwhile. After your initial fixed-interest rate period, your lender will adjust your rate based on the index it’s tied to. Points might make sense with a rate that adjusts at 10 or seven years, but probably not at five years.
ARE MORTGAGE POINTS TAX-DEDUCTIBLE?
Discount points can be deductible as mortgage interest on a primary residence or on a second home, even if it’s being rented out. However, there are some caveats.
— The loan must be secured against your home, whether it’s for a purchase or to build and improve the home
— The money to buy the points must be paid directly to the lender
— If you pay points to refinance a mortgage, you may have to spread out the deduction over the entire loan term
Consult a tax professional if you have questions about the deductibility of mortgage points and interest.
Buying points may or may not be a great way to reduce your housing costs. Take the time to do some calculations and think through the various scenarios. Consider whether you’d be better off investing that point money or using it for a bigger down payment.