How do Mortgage Points Work?
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What are mortgage points?
Mortgage points, also known as mortgage discount points, are fees that buyers can choose to pay lenders in return for a lower mortgage rate on their loan. The process of buying points for a mortgage is known as “buying down the rate”.
It is a trade-off where funds are paid upfront to reduce the mortgage rate, which will eventually save interest in the future. A lower mortgage rate will result in a smaller monthly mortgage payment and lower total interest paid over the life of the mortgage.
Mortgage points fees are part of closing costs and the estimate is on the loan estimate document, which buyers get after they apply for a mortgage loan. The real amount is on the closing disclosure document which is received before closing.
How much is a mortgage point?
Mortgage discount points cost 1% of the mortgage amount and result in a drop of 0.25% in the mortgage rate per point. For example, on a mortgage amount of $100,000, 1-point will have a fee of $1,000 and can reduce the mortgage rate from 4.25% to 4%.
One point can reduce the point by about 0.25%, but the exact drop depends on several factors such as the lender, type of mortgage, and daily mortgage rates. You don’t necessarily need to buy a full point. If you have fewer funds after the down payment and closing costs , you can choose to buy 0.5 points and reduce your mortgage rate by 0.125% instead. For example, on a $100,000 mortgage amount, instead of paying $1,000 for 1 point, you can pay $500 for half a point. If you have additional funds, you can choose to buy 1.25 points also.
How do mortgage points work?
The mortgage rate has an impact on your monthly mortgage payment, as the rate decreases, your mortgage payment also goes down. The total interest savings depends on the mortgage rate, the amortization term ( 15-year vs 30-year ), and the total amount borrowed. For example, on a 30-year fixed-rate mortgage with various points and interest savings:
| No Points | 1 Point | 2 Points | |
|---|---|---|---|
| Loan Amount | $300,000 | $300,000 | $300,000 |
| Mortgage Rate | 4% | 3.75% | 3.5% |
| Points Cost | - | $3,000 | $6,000 |
| Monthly Payment | $1,530 | $1,490 | $1,460 |
| Total Interest | $172,485 | $160,130 | $147,975 |
| Lifetime Savings | - | $12,355 | $24,510 |
The example above shows how discount points work. If you choose to buy 1 point for $3,000, over the life of a 30-year mortgage you will save $12,355, and with 2 points you will save $24,510. However, this is under the assumption you stay in the home for 30 years.
Mortgage Points: Is It Worth It?
Should you buy mortgage points?
Whether you should buy mortgage discount points depends on whether you can afford mortgage points and how long you plan to stay in the home, known as the break-even period. You reach the break-even point when the accumulated savings from the points equal the cost of purchasing the points. For example, if your monthly savings because of the points is $50, and the total cost of the point was $2,500 then you will break-even in 50 months ($2,500/$50) or about 2 years.
What this means is if you stay in the home long enough, the savings from the smaller monthly payments will pay off the mortgage points fee and from that point, you will start saving money. However, if you choose to sell the home before the break-even period or refinance your mortgage then you will end up losing money. Therefore, if you plan on staying in the home forever or at least past the break-even, it will be worth it. The break-even point will depend on the size of the loan, cost of the points, and the term of the loan.
Are mortgage points worth it?
Discount points will be worth the cost if you are planning to stay in the home for a long period of time. The savings from the reduced mortgage rate will really accumulate over the entire mortgage term. Therefore, if you can afford discount points after all other costs and you are staying in the home for a long period, discount points can be worth it.
For Example:
The above example shows that if you buy a discount point and reduce the mortgage rate by 0.25%, you must stay in the home for at least 2.5 years to recoup the cost of buying a point. If you move or refinance the mortgage before 2.5 years, then purchasing discount points will not be worth it. You can also consider using those funds for a larger down payment which will also result in a lower interest rate.
Reasons not to buy mortgage points
There are four reasons not to buy mortgage points:
- Short-term stay: You plan to leave the home in a couple of years, prior to the break-even, making the use of discount points redundant.
- Extra mortgage payments: If you plan on making early mortgage payments that end the mortgage early, then the savings from discount points may not materialize.
- Lower savings: If your savings get depleted from the down payment and closing costs then you should not buy mortgage discount points.
- Minimum down payment: If the funds used for the mortgage points can instead be used for the down payment to help you reach 20%, then you should use it for the down payment to avoid private mortgage insurance (PMI). A larger down payment will lower your loan-to-value (LTV) ratio which can help get you a lower rate and allow you to gain more home equity.
Frequently Asked Questions
Can I choose to buy mortgage points after closing?
No, the terms and conditions of the loan are decided before closing and therefore cannot be altered with discount points.
How do mortgage points work with an adjustable-rate mortgage (ARM)?
Adjustable-rate mortgages are linked to a benchmark index and a credit spread. The rate is variable because your mortgage rate changes when the benchmark index rises or falls. The benchmark index can be the prime rate that is linked to the Fed funds rate. Mortgage points on an ARM are similar to a fixed-rate mortgage, however, the mortgage will adjust after a couple of years, so it is important to know the break-even point.
What are mortgage origination points?
Mortgage points can be categorized into two types, discount points and origination points. This article was focused on mortgage discount points and interest reduction. Whereas, mortgage origination points are fees paid to lenders as part of closing costs to process the loan. This will involve all the paperwork on your loan, processing, and service charges. It is also 1% of the loan amount but can be negotiated if you have a good credit score, income, and other lenders available.
Are mortgage points tax deductible?
Yes, if you itemize your deduction, you can deduct mortgage discount points. The amount deducted is dependent on the amount you borrow, the maximum interest that can be part of the deduction is up to $750,000 of mortgage debt. It has to be your primary residence and points cannot be deducted all in one year, rather it is spread out and deducted based on the interest charged that year. Origination points are not tax-deductible.
Can I negotiate the fee for purchasing discount points?
Yes, as with most closing costs which are variable and can be negotiated, discount points can also be negotiated. If you have a good credit score and high income, you can negotiate with the lender to give you a better rate than the quoted rate. You can also reach out to multiple lenders and shop around for the best rate. Lenders will try their best to win your business and will be more negotiable regarding the mortgage points fee.
How many mortgage points can I buy?
There is no set limit to the number of points you can buy as it varies from lender to lender. However, most lenders will not allow you to purchase more than 4 mortgage points as there are limits to how much can be paid during closing. Federal and state limits prevent buyers from paying more than a certain limit in closing costs , hence, excess points cannot be purchased.