Mortgage points and how they can cut your interest costs

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Mortgage rates continue to dip, falling to almost historic lows, but borrowers can obtain even lower rates by purchasing mortgage points. This strategy means borrowers pay a mortgage lender for a lower interest rate upfront for the next 15 or 30 years.

While this concept appears like a simple solution, it may not benefit all homeowners, depending on how long they live in their home.

Buying mortgage points is a complicated process. Understanding the ins and outs of this option will help you determine if you will save money over the long run compared to other choices, such as refinancing.

What are mortgage points?

Mortgage points are one way for homeowners to lower their interest rate. When you pay for points on a mortgage, you are actually paying interest right now for the loan. In return, the homeowner can lock in a lower and discounted rate. The rate depends on how many points are purchased. Your mortgage rate will drop more if you purchase more points.

Typically, one point means a discount of 0.25 percent from the mortgage rate. The borrower pays 1 percent of the total mortgage amount.

If a homeowner obtained a $200,000 mortgage, one point would cost $2,000. Your mortgage rate would decrease by 0.25 percentage points or a 4 percent mortgage would fall to 3.75 percent. Homeowners can buy more than one point, depending on their financial situation.

The majority of lenders provide this option to homeowners. Not all homeowners choose this route since refinancing is also an option.

The points will be listed on the Loan Estimate, a formal document that includes the major details of the loan. Another form, the Closing Disclosure, will also itemize the points. This form is given to borrowers before settlement of the final mortgage terms. Mortgage points are paid when the mortgage is closed.

Borrowers can use Bankrate’s mortgage calculator to figure out if buying points is worth it.

What are discount points?

Mortgage points come in two flavors: discount points and origination points, McBride says. Discount points are prepaid interest and used to “buy down” your interest rate, which can result in “substantial savings” if you have the loan and its lower monthly payments for a long time, he says.

Mortgage discount points are a fee paid to lower the interest rate on a mortgage loan, which amounts to 1 percent of the mortgage. For a $200,000 mortgage, one point costs $2,000.

What are origination points?

Origination points are a fee paid for providing the loan. Origination points are a direct compensation to the lender, or a means of rolling various fees into a package and follow the same 1 percent guideline.

Can you negotiate mortgage points?

Some lenders allow borrowers to negotiate mortgage points.

Homebuyers who have a 20 percent down payment and high credit score will be “best positioned to negotiate the origination points,” says Jackie Boies, a senior director of housing and bankruptcy services for Money Management International, a Sugar Land, Texas-based nonprofit debt counseling organization.

“A terrific credit score and excellent income will put you in the best position,” she says.

Origination points are frequently reduced by lenders to entice these borrowers, Boies says.

Are mortgage points tax-deductible?

Another tax break for homeowners are mortgage points because they are tax-deductible and will lower the amount you pay to the IRS.

Prepaid interest is tax-deductible on the first $750,000 borrowed, says Greg McBride, chief financial analyst for Bankrate. This is the amount for the maximum deduction. Individuals who have a mortgage exceeding $750,000 cannot deduct the points for the remainder of the amount.

Mortgage-related services, such as appraisal, title and notary fees, are rolled into an origination fee and are not tax-deductible, Boies says.

“Points may be tax-deductible in the year that you pay them with a host of requirements being met,” she says.

The requirements to claim a tax deduction for both mortgage interest and points include taxpayers itemizing their deductions on Schedule A, McBride says.

Here are the other requirements from the IRS:

  • The loan must be secured against your home, but you can also build and improve on the home.
  • The money to pay for the points needs to be paid only to the lender.
  • The points paid are not more than the amount typically charged in that area.
  • Borrowers must pay for the points at closing and not borrow the amount from a lender.

When homeowners refinance, the points they buy to lower the interest rate are also tax-deductible, but they are “deducted over the life of the loan rather than all in year one,” McBride says.

Talk to a tax professional such as a CPA if you are not sure about what can be deducted.

How mortgage points work with ARM loans

Mortgage points on an adjustable-rate mortgage (ARM) work just like a fixed-rate mortgage. Since the majority of ARMs are five or seven years, consider whether you will live in the home long enough for the points to pay off.

“But factor in the likelihood that you’ll eventually refinance that adjustable rate because you may not have the loan long enough to benefit from the lower rate you secured by paying points,” McBride says.

What is the value of adding points to your mortgage?

The value of adding points to your mortgage means a homeowner will pay a lower interest rate. A lower interest rate helps homeowners pay less towards the interest portion of the loan and more toward the principal amount, especially if extra payments are being made.

Homeowners should consider the size of the home, its location, their current job situation and other factors, since they all impact how long they will live there.

“The added cost of mortgage points to lower your interest rate makes sense if you plan to keep the home for a long period of time,” Boies says. “If not, the likelihood of recouping this cost is slim.”

For many average homeowners, paying points on top of the other costs of the homebuying process may stretch their savings too much, she says.

“If you do have funds available, it may also make financial sense to apply these funds to a larger down payment,” Boies says. “We encourage homebuyers to use a mortgage calculator to help determine if you should pay points.”

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