What Are Mortgage Points?
How to know if paying discount points on a mortgage will save you money.
Low mortgage rates have been stealing the headlines lately. I recently wrote an article about how to qualify for a mortgage or a refinance because so many people have asked me about buying real estate or refinancing their existing home loan. An important part of shopping for a mortgage is to evaluate whether paying points can save you money. Mortgage points are a topic that trips up a lot of people, especially first-time home buyers. So even if you’re not in the market for a home right now, be sure to pay attention. I’ll explain points and give you some online tools to help you figure out whether you should pay points or not.
What Are Mortgage Points?
When you shop for a home loan, you’ll find that they’re available with and without the option to pay points. A mortgage point, also known as a discount point, is 1% of the loan amount. For example, if you borrow $200,000, one point equals 1% of that amount, which is $2,000. Two points would be 2% or $4,000, and so on. Points must generally be paid upfront at closing and they don’t reduce the amount you borrow—you have to pay points in addition to your loan amount.
What are the Benefits of Paying Mortgage Points?
It sounds strange that anyone would want to pay more upfront for a mortgage or a refinance than they had to, but there’s a huge benefit to paying points: You get a lower interest rate. Points give you a way to prepay a lump sum of interest in exchange for a lower interest rate over the entire term of the loan. Paying points is also called “buying down” the rate. A lower rate means that you pay a lower monthly mortgage payment and less total interest over the life of a loan, which is fantastic!
How Much Will Points Reduce a Mortgage’s Interest Rate?
How much paying points will reduce a mortgage’s interest rate varies by lender. However, it’s generally reduced by about one quarter of a percentage point (0.25%) for every discount point that you pay. I know that might sound a little confusing, but stick with me.
Here’s an easy example: Take the $200,000 loan that I mentioned earlier, where you pay one point or $2,000 upfront. If the interest rate on the loan is 5% without points, buying one point for $2,000 could reduce the rate to 4.75%. Going from 5% to 4.75% is a reduction of a quarter of a percentage point. If you paid two points on this loan, or $4,000, you could reduce the interest rate by an additional quarter of a percentage point, down to 4.5%. Though buying points can reduce the interest you have to pay, it doesn’t always necessarily save you money in the long run. So how can you know when buying mortgage points is worth it?
Should You Buy Mortgage Points?
The answer depends on whether you have enough available cash and how long you’ll have the loan. The longer you keep a loan—before refinancing or selling the property—the more buying down the rate makes sense. There’s a break-even point where you fully recoup what you paid in points and begin to save money. It’s important to estimate the break-even point because if you don’t keep the loan long enough, paying points is a losing proposition.
Example of a Points Break-Even Calculation
Calculating when you break-even on paying points is easy. You simply need to know what the monthly mortgage payment would be with and without paying points. Let’s say you could save $30 a month by paying one point or $2,000. If you divide the cost of your points by your monthly savings, you see that it would take almost 67 months, or about five and a half years to recoup the $2,000 expense ($2,000 / $30 a month = 66.67 months / 12 months = 5.5 years). So, for this example, if you didn’t plan on keeping the mortgage for at least five and a half years, buying points wouldn’t be profitable for you.
Mortgage Points Tax Deduction
A break-even date should be used as a rough guideline for deciding whether to pay points or not. It’s how you determine the length it’ll take to make paying points worthwhile, but it doesn’t factor in everything, such as the amount of mortgage interest you can deduct from your taxes. Since points are prepaid interest, they’re also tax-deductible. When you’re buying or building your primary residence, points that you (or a seller) pay are fully deductible in the year the loan is closed.
However, be aware that tax deductions for points paid to buy a second home or for a refinance generally have to be spread out evenly over the life of the loan. So for a 15-year refinance, for instance, you could only deduct one fifteenth of the amount of points from your taxable income each year. For more details about points, refer to IRS Publication 936, Home Mortgage Interest Deduction.
Mortgage Points Calculators
Online mortgage points calculators are all a little different. I like the one at dinkytown.com because it helps you analyze whether you should pay for points or use the money to increase your down payment and borrow less. Remember that when you put 20% down you can avoid having to pay private mortgage insurance or PMI. Mortgage101.com also has a good calculator that shows your monthly net savings if you chose to invest your money, instead of using it to buy points.
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IRS Information About Home Mortgage Points
IRS Publication 936, Home Mortgage Interest Deduction
LendingTree Mortgage Points Calculator