Mortgage points and how they can cut your interest costs
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 savvy homebuyers buy mortgage points, also called “discount points,” to lower the amount of interest they pay.
What are mortgage points?
Mortgage points are fees a buyer pays a mortgage lender 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.
Homebuyers 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.
How much each point lowers the rate varies among lenders. The rate-reducing power of mortgage points also depends on the type of mortgage loan and the overall interest rate environment.
Points are paid at closing and are 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 discount points vs. APR
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 gobs of money.
The key is staying in the home long enough to recoup the prepaid interest. If a buyer sells the home after only a few years, refinances the mortgage or pays it off, buying discount points could be a money-loser.
Here is an example of how discount points can reduce costs on a 30-year, fixed-rate mortgage in the amount of $200,000.
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.
To calculate the “break-even 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 housing and bankruptcy services for Money Management International, a nonprofit debt counseling organization based in Sugar Land, Texas. “If not, the likelihood of recouping this cost is slim.”
What are mortgage origination points?
There is another type of mortgage points called “origination” points. Origination points 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.
Sometimes, origination points can be negotiated. Homebuyers who put 20 percent down and have strong credit have the most negotiating power, says Boies.
“A terrific credit score and excellent income will put you in the best position,” Boies says, noting that lenders can reduce origination points to entice the most qualified borrowers.
Mortgage points and ARM loans
Mortgage points on an adjustable-rate mortgage (ARM) work like points for a fixed-rate mortgage, but most ARMs adjust at five years or seven years, so it’s even more important to know the break-even point before buying discount points.
“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,” says Greg McBride, CFA, chief financial analyst for Bankrate.
Are mortgage points tax-deductible?
Mortgage discount points, which are prepaid interest, are tax-deductible on up to $750,000 of mortgage debt. Taxpayers who claim a deduction for mortgage interest and discount points must list the deduction on Schedule A of Form 1040.
“That generally isn’t a problem for homebuyers, as interest on your mortgage often is enough to make it more beneficial to itemize your deductions rather than taking the standard deduction,” says Boies.
However, unless you can meet a host of IRS requirements, you cannot take a deduction for all of the points you paid in the same tax year. Each year, you can deduct only the amount of interest that applies as mortgage interest for that year. Points are deducted over the life of the loan rather than all in one year.
Origination points, on the other hand, are not tax-deductible.
“Points that are not interest but are charges for services such as preparing the mortgage, your appraisal fee or notary fees can’t be deducted,” says Boies.
Consult a tax professional if you are not sure about what homebuying expenses are tax-deductible.
Buying mortgage points can be a big money-saver if you can afford it and you plan to stay in the home long enough to reap the interest savings.
For many homeowners, however, paying for discount points on top of the other costs of buying a home is too big of a financial stretch. In addition, buying points is not always the best strategy for lowering interest costs.
“It may make financial sense to apply these funds to a larger down payment,” says Boies.
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.
Overall, homebuyers 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 house and their job situation, then figure out how long it would take them to break even before buying mortgage points.
- Compare current mortgage rates
- How to get the best mortgage rate
- How to negotiate mortgage closing costs