Buying a home or refinancing a mortgage is a huge financial move! Laura helps you understand what mortgage points are and how to know if they're worth paying for as you shop around.
If you're shopping for a home mortgage, you've probably seen the term "mortgage points." Before you take the next step to sign a mortgage preapproval or other borrowing commitment, it's critical to understand how points work.
Taking out a mortgage is a big financial decision, so don't miss the opportunity to take advantage of mortgage points when it's wise for your situation. Paying points can help you get the best deal possible on your next new home.
1. Why mortgage points can help home buyers
Mortgage points, also known as discount points, reduce the interest rate you pay on a home loan. While you must pay them upfront, they typically save money over time.
Every mortgage point you buy reduces a loan's annual percentage rate (APR) by 0.25%. So, if the original APR is 4.5%, paying one mortgage point knocks it down to 4.25%. Paying two points reduces the rate to 4%, and so on. So, the more points you buy, the lower your interest rate.
For example, if you're shopping for a $300,000, 30-year, fixed-rate mortgage at 4.5%, your total interest would be $247,220. But if you bought three mortgage points, your 3.75% rate would mean paying $200,165 in interest. That's a massive interest savings of more than $47,000 over the life of the loan!
2. How much home buyers pay for mortgage points
One mortgage point typically costs 1% of your home loan amount. So, if you want to borrow $300,000 to buy a property, one mortgage point would cost $3,000. You'd have to pay $6,000 for two and $9,000 in the previous example with three points, and so on.
Most homebuyers who opt for points buy between one and three and have the option to purchase fractions of points. However, the challenge for buyers is that lenders typically require you to pay points up front. Since the cost gets included in the total amount you must bring to the closing, you must have it in savings.
3. The pros of paying mortgage points
As I mentioned, paying a few thousand dollars upfront can save tens of thousands of dollars in the long run. When you get an APR discount that allows you to break even, paying points is worth it. More about breaking even in a moment.
In addition to paying less interest and lower monthly payments, mortgage points are tax-deductible. Mortgage interest, including prepaid points, reduces your taxes when you're eligible to claim it.
You also enjoy a reduced monthly payment when you get a lower interest rate on a fixed-rate mortgage. So, paying points can be an excellent way to keep the cost of a home within budget.
For example, if you get a $300,000, 30-year, fixed-rate mortgage at 4.5%, your monthly payment would be about $1,520. But if you bought three points, discounting the rate to 3.75%, your monthly payment would be $1,389, saving about $1,500 a year.
In addition to paying less interest and lower monthly payments, mortgage points usually qualify as tax-deductible mortgage interest. When you itemize deductions on Schedule A, you can include a certain amount of mortgage interest, including prepaid points, to reduce your tax liability.
The IRS specifies that separate lender fees are not the same as mortgage interest. So, it doesn't qualify as a tax deduction if you buy mortgage points to reduce your origination fee instead of your interest rate. You can learn more about mortgage points on the IRS website, or by consulting with a tax expert, mortgage lender, or real estate professional.
4. The cons of paying mortgage points
Mortgage points have many benefits, but there are cons to consider. As I mentioned, a common challenge is being short on savings and not being able to afford them. If you borrow $100,000 to buy a home, paying for three points means you need to spend an extra $3,000.
With low inventory, high home prices, and rising interest rates in our current real estate market, budgets can be stretched thin even for minimum closing costs without points. So, if you don't have the extra funds to pay points and maintain a healthy cash reserve, buying them may not be best.
Don't forget your monthly payment has four components known as PITI: principal, interest, taxes, and insurance. Before you start searching for your dream home, get familiar with typical homeowners insurance rates where you want to live and plug it into an online mortgage calculator to know exactly how much home you can afford.
Another con for points that I mentioned is not reaching a break-even, which is the number of months it takes for your interest savings to exceed the price paid for points. For example, for a $200,000, 30-year, fixed-rate mortgage at 4.5%, you’d pay $1,010 per month. Paying $2,000 for one point would discount the rate to 4.25%, reducing your payment to $983, a $27 per month savings.
To break even, you'd need to make payments for 75 months, which is more than six years ($2,000 cost / $27 savings = 74.1 months). If you sold the property before living there for 75 months, you'd lose money on buying points. So, if you're not sure how long you'll stay in your home or think there's a chance you may need to move before the break-even point, buying points won't help you.
Another potential con for mortgage points is buying them before interest rates go down. That would likely give you the ability to refinance for a lower rate without buying them. Consider the interest rate environment so you don't needlessly buy points.
Also, remember that every financial move comes with an opportunity cost for doing something else with your money. For instance, paying $5,000 on points would save $20,000 on mortgage interest. But what if you invested the money for 30 years with an average 8% return? That would allow you to potentially earn $45,000, more than double your interest savings.
5. How to know if paying mortgage points is worth it
While paying mortgage points can save money over the life of a loan, it isn't for every home buyer. To sum up, paying discount points may not make sense if:
- You don't have enough savings.
- You won't or don't know if you'll remain in a home past the break-even point.
- You think interest rates will drop soon.
- You believe you can earn more by investing excess cash.
When you shop for a mortgage, watch out for rates that sound too good to be true because they likely include points. Ask lenders for rates with and without points to make an apples-to-apples comparison and carefully crunch the numbers.
Get guidance from one or more mortgage professionals if you're unsure what type of mortgage you should get and if discounting it is best for your situation.