Buying a house is the most expensive purchase most of us will ever make, so naturally, anything that can reduce the cost of a mortgage is worth looking at. Besides negotiating a good price and shopping for the best mortgage rates, some homebuyers buy mortgage points, also called “discount points,” to lower the amount of interest they pay.
What are mortgage points and how do they work?
Mortgage points are the fees a borrower pays a mortgage lender in order to trim the interest rate on the loan. This is sometimes called “buying down the rate.” Each point the borrower buys costs 1 percent of the mortgage amount. So, one point on a $300,000 mortgage would cost $3,000.
Each point typically lowers the rate by 0.25 percent, so one point would lower a mortgage rate of 4 percent to 3.75 percent for the life of the loan. How much each point lowers the rate varies among lenders, however. The rate-reducing power of mortgage points also depends on the type of mortgage loan and the overall interest rate environment.
Borrowers can buy more than one point, and even fractions of a point. A half-point on a $300,000 mortgage, for example, would cost $1,500 and lower the mortgage rate by about 0.125 percent.
The points are paid at closing and listed on the loan estimate document, which borrowers receive after they apply for a mortgage, and the closing disclosure, which borrowers receive before the closing of the loan.
Mortgage origination points are another type of mortgage points. They are fees paid to lenders to originate, review and process the loan. Origination points typically cost 1 percent of the total mortgage. So, if a lender charges 1.5 origination points on a $250,000 mortgage, the borrower must pay $4,125.
Origination points differ from discount points in that they do not directly reduce the interest rate of the loan. Some lenders allow borrowers get a loan with no or reduced closing costs or origination points, but compensate for that with higher interest rates or other fees.
Mortgage discount points are a type of prepaid interest. When you pay for these points, you reduce the interest rate of your loan, typically by 0.25% per point. You can often buy a fraction of a point up to 3 points or possibly more.
By reducing the loan’s interest rate, you can lower your monthly payment. However, keep in mind that this requires an upfront payment. Typically, the longer you plan to live in a home, the more benefit you’ll get from paying for points.
Mortgage discount points vs. APR
Buying discount points on your mortgage is effectively a way of prepaying some of your interest, and looking at the annual percentage rate (APR) can help you compare loans with different rate and point combinations. The APR incorporates not just the interest rate, but also the points you pay and any fees the lender will charge. Check out a quick explanation from Greg McBride, CFA, Bankrate chief financial analyst:
Example of how mortgage points can cut interest costs
If you can afford to buy discount points on top of the down payment and closing costs, you will lower your monthly mortgage payments and could save lots of money. The key is staying in the home long enough to recoup the prepaid interest. If you sell the home after only a few years, or refinance the mortgage or pay it off, buying discount points could be a money-loser.
Here is an example of how discount points can reduce costs on a $200,000, 30-year, fixed-rate mortgage:
In this example, the borrower bought two discount points, with each costing 1 percent of the loan principal, or $2,000. By buying two points for $4,000 upfront, the borrower’s interest rate shrank to 3.5 percent, lowering their monthly payment by $56, and saving them $20,680 in interest over the life of the loan. (However, to save the full $20,680, the borrower would have to live in the home for the full term of the loan, 30 years, and never refinance.)
What is the breakeven point?
To calculate the “breakeven point” at which this borrower will recover what was spent on prepaid interest, divide the cost of the mortgage points by the amount the reduced rate saves each month:
$4,000 / $56 = 71 months
This shows that the borrower would have to stay in the home 71 months, or almost six years, to recover the cost of the discount points.
“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,” says Jackie Boies, a senior director of Partner Relations for Money Management International, a nonprofit debt counseling organization based in Sugar Land, Texas. “If not, the likelihood of recouping this cost is slim.”
Are mortgage points right for you?
Buying mortgage points is a way to pay upfront to lower the overall cost of your loan and reduce its monthly payment. It makes the most sense if you plan to be in the home for a long period of time. The amount you’ll save each month is likely to make the upfront cost worth it.
Of course, if you don’t plan to stay in a home for a long time, paying points is likely to lose you money overall.
Another consideration is whether you should put money toward points or a larger down payment. A larger down payment can often help you secure a lower interest rate anyway. Additionally, hitting the 20% down payment mark can also let you avoid the additional cost of PMI.
A bigger down payment can get you a better interest rate because it lowers your loan-to-value ratio, or LTV, which is the size of your mortgage compared with the value of the home.
Borrowers should consider all the factors that could determine how long they plan to stay in the home, such as the size and location of the property and their job situation, then figure out how long it would take them to break even before buying mortgage points.