When you are purchasing a home, you have a lot of decisions to make. One of them is whether you want to increase your closing costs and lower your interest rate with mortgage points, or discount points. So, what are mortgage points and when does it make sense to use them?
What is a Mortgage Point?
A mortgage point is equal to 1% of your mortgage loan, and buying points is a way to lower your interest rate. This means for every $100,000 of the mortgage, one point equals $1,000.
In general, the longer you plan to own the home, the more points help you save on interest over the life of the loan.
There are two types of mortgage points to consider: origination points and discount points.
Origination points, also called origination fees, cover some of the costs of the loan, including fees charged by the loan officer or broker. On average most lenders charge approximately 1 origination point. These mortgage points are not tax deductible.
A discount point is essentially prepaid interest, and is also known as “buying down the rate” on a mortgage. Buying discount points can help you lower your monthly mortgage payment. The amount of rate reduction per discount point varies between lenders.
Because you are paying less interest, your monthly mortgage payments will be lower as well. Most lenders will allow you the opportunity to buy up to 4 discount points and are tax deductible.
When deciding whether or not to pay for discount points, you first you need to know how long you plan on living in the home.
Here’s an example, from PennyMac:
If you have a four percent interest rate on a $200,000 mortgage, your monthly mortgage payment would cost roughly $955 per month. If you buy one mortgage discount point—or pay $2,000 upfront—your interest rate may drop to 3.75 percent, lowering your monthly payment by roughly $29 per month.
The Benefit of Paying Points
Under the right circumstances, the paying of points can benefit the lender as well as the borrower. Here’s how:
- The lender gets an increased upfront profit because the borrower is paying more than the stated interest rate.
- The borrower can save money over the life of the loan, by securing a lower interest rate.
When Does it Make Sense to Use Points?
Many home buyers choose to pay mortgage points at closing. The goal here is to reduce the interest rate over the term of the loan. But when does it make sense to do this?
If you plan on selling the home, or paying off the loan within 5 years then discount points are useless, and could end up costing you more. However, if you plan on staying in the home for a long time using some discount points will save you a lot of money in interest.
At some point during the payback period, you will reach the break-even point. This is where the money you save begins to exceed the amount you paid to buy down the rate.
The break-even point is when your total savings exceed the cost of paying for mortgage points at closing. If you sell or refinance the home before reaching this point, you’ll have a net loss instead of a gain. So you need to think about your long-term plans before making a decision.