One strategy for lowering your mortgage interest rate and the overall cost of your loan is to pay mortgage points up front. What are mortgage points, how can paying them save you money, and when is that the right choice for you?
What are mortgage points?
A point is simply one percent of the amount of money being borrowed. On a $100,000 loan, for example, one point equals $1,000.
Points are applied in a couple of different ways, and it’s important to know the difference. Mortgage companies usually charge an origination fee equal to one point. These origination points are a one-time fee the lender charges the borrower for processing the loan.
The points that can save you money on your mortgage are known as mortgage points or discount points, and paying them is sometimes referred to as “buying down the interest rate.” Here’s how it works. The mortgage company offers to lower the interest rate it’s charging you on the loan in exchange for you paying points up front at the loan’s inception. It’s a means of prepaying interest and thus lowering your monthly payments.
For example, assume your lender is offering a $250,000 loan at 4.5 percent. The mortgage company may offer to reduce that interest rate by a quarter-point in exchange for you paying one mortgage point at closing. (There is not a direct ratio of points paid to interest rate reduction.) If you choose to pay that mortgage point — $2,500 — at closing, you’ll reduce your monthly interest rate to 4.25 percent. This reduces your monthly mortgage payment, potentially saving you many thousands of dollars in interest over the term of the loan.
Mortgage points paid at purchase are fully deductible on your federal income taxes if you itemize deductions. Mortgage points paid for a refinance are deducted on a prorated basis over the life of the loan, again assuming you itemize deductions.
Sometimes lenders require a borrower with a riskier credit profile to prepay points as a condition of loan approval. In this case, the lender is collecting some of its interest up front as a hedge against borrower default.
When does paying mortgage points make sense?
Here’s what you should consider in making the decision whether to prepay mortgage points. First, how long do you intend to stay in the house? Paying points makes sense only if you will stay in the home long enough to break even on the payment. To determine how long you need to keep your home to make paying points worthwhile, divide the amount of money paid in points by your monthly savings. For example, if you pay $2,500 in points up front and will save $50 per month as a result of that payment, then you will recover your $2,500 investment in 50 months. Do you plan to live in the house long enough to recover the initial cost?
Also factor in the amount you’ll save in income taxes in the year of purchase by paying mortgage points. And consider whether your money could be put to a more profitable use. Would you benefit more by not paying points and instead investing that money in something that performs better over time?
How much down payment?
The amount of your down payment is another important factor in whether your should pay mortgage points. If you put down less than 20 percent of the cost of the house, your lender will require you to pay a monthly fee for private mortgage insurance (PMI) to protect the lender in case you default on your mortgage. This PMI payment will offset some of the savings you get from paying points. It may make financial sense to use your money to make a bigger down payment and avoid PMI rather than to pay points.
Lender tools to make the decision
Your lender should have a mortgage calculator app on its website that you can use to calculate various down payment and points paid scenarios and see which strategy works best for you.