Points on a mortgage are fees paid to the lender during closing in exchange for a reduced interest rate on your mortgage loan as well as your monthly payment. Basically, one mortgage point equals 1% of the amount of the mortgage. Buying a home can be a great investment; hence, it is vital for homeowners to know what are the points on a mortgage and decide whether it is the right choice for them.
In this article we will cover the following topics:
- Discount Points
- Origination Points
- How do Mortgage Points Work?
- How Discount Points Affect Monthly Payments?
- Is it a Good Idea to Buy Mortgage Points?
- Comparing Mortgage Loan Offers
- Are Mortgage Points Tax Deductible?
- Points for Adjustable Rate Mortgages (ARMS)
This article is part of a series ‘All About Mortgages.
In the world of housing, there are two types of mortgage points. They include:
1. Discount Points
Discount points are basically the prepaid interest on the mortgage loan. In this mortgage point, the price you pay for points will impact the total interest of the loan directly. The more points you purchase, the lower the interest rate you will pay on your mortgage.
Thus, paying points is known as the“ buying down the rate” and borrowers can pay anywhere from one to three discount points based on how much they want to reduce their mortgage interest rate. This will also depend on the type of home loan, the lender’s terms, and the overall housing market.
2. Origination Points
The other kind of points is the origination points that compensate the expenses of the lender when processing the loan. Origination costs usually pay for the closing costs, and the number of origination points charged may vary from one mortgage provider to another. Unlike the discount points, this mortgage point does not lower your interest rate.
Although not all lenders charge origination fees, those that do are most likely willing to negotiate. Therefore, before you settle for a particular mortgage lender, ensure that you enquire about the origination point’s fee.
How Do Mortgage Points Work?
Once you apply for a mortgage, your mortgage lender will offer you discount points with the aim of lowering your interest rate when you acquire the mortgage loan. Basically, one discount point is equivalent to 1% of your total loan amount. A discount point can lower your interest rate by one-eighth to one-quarter of a percent. However, there is no set amount for which the discount point will lower your mortgage rate as the effect varies with the type of loan, lender, and the prevailing market rates.
How Discount Points Affect Monthly Payments?
Since paying discount points reduces the interest rate of the mortgage loan amount, you can expect that the monthly payment will also reduce. For instance, if you obtain a 30 year fixed rate mortgage for $100,000 at 5% interest, the monthly principal and interest without discount points will be $537. If you purchase three discount points at closing, your interest rate will reduce to 4.25% and your monthly mortgage payment would be $492.
If you pay three discount points, it will cost you $3000 for monthly savings of $45 ($537-$492). To determine after how long you will get back that money, you need to divide the cost of purchasing the mortgage points by the monthly savings. In this case, it will be $3000/$45 which gives 67.
Therefore, in order to break even on the purchase point, you will have to keep the house for 5 years and 7 months or 67 months. Since the 30 years loan lasts 360 months, buying mortgage points would be a great idea only if you plan to live there for a long period of time. This means that you will save money in the long run if you stay for longer than 67 months.
Nonetheless, it might not work well if you only plan to live in your home for only a few years. In this instance, you may want to buy fewer or no points. Therefore, before you decide whether to purchase discount points, it is wise to consider the length of time you plan to own the home.
However, it is important to note that this example only covers the principle and interest of the loan and not the property taxes. The only way to figure out the accurate break down of the monthly payments is by using a mortgage calculator.
Comparing Mortgage Loan Offers
Mortgage points also come in handy in helping you compare the loan rates offered by different lenders. If you are loan shopping and get two lenders that offer the same rate but one lender is charging a point while the other isn’t, you will get a better deal with the lender that doesn’t charge a point.
While both lenders offer the same rate, you will have to part with an upfront fee for the one that charges a fee. Because of this, it pays to shop for the loans carefully and ensure that you fully understand the terms before committing to a particular lender.
Is It a Good Idea to Buy Mortgage Points?
Before you buy mortgage points, it is important to take some factors into consideration. Here is what you need to know if you are wondering what are the points on a mortgage and whether they can be beneficial for you.
1. Determine how long you want to live in your home
Buying mortgage points will help you save more money when you keep the mortgage for longer. However, if you plan to live in your home for a short period of time, it would be wise to pay lower closing costs and make higher monthly mortgage payments. Paying points may also not be a good idea if you plan to refinance your mortgage in a few years’ time.
2. Consider the amount you have to put down at down closing
Your mortgage insurance is another vital aspect that you need to keep in mind. Buying points could be useful if you have adequate cash to make a down payment and still be left with enough to lower the interest rate.
Most people who don’t have enough money to pay for the down payment for their home purchases are barely left with enough money to purchase points. You need to do your math and determine whether you have enough money to purchase points. For instance, it makes sense to purchase three discount points on a $100,000 which will cost $3000 rather than on a $500,000 home that will cost $15,000.
Also, if your loan is conventional and your down payment is below 20%, you will need to pay Private Mortgage Insurance (PMI) that may cost around 1% of the amount loan. If the mortgage loan amount is $300,000, the PMI will be $3000 each year or $250 a month. It is important to always use a mortgage calculator to see if the discount points cost more or less than the monthly PMI fees. Also, if you are considering a conventional loan, be sure to inquire about the PMI rates as they may vary from one lender to another.
3. Break-Even Period
The other thing to keep in mind when considering buying mortgage points is the breakeven period. The breakeven period is the time it will take you to regain the upfront fees of buying the mortgage points. The breakeven point occurs when the accumulated monthly savings is equivalent to the upfront costs.
From the example above, the breakeven point will be the cost of the points ($3000) divided by the saving per month ($45). This gives 67 months. In 67 months, you would have saved over $3000 in interest. Once you hit the breakeven point, you will save $45 each month.
However, losing cost on the discount points paid occurs if you refinance the mortgage or sell the home before you hit break-even. To determine the breakeven period, divide the cost of discount points by the accumulated monthly savings.
Are Mortgage Points Tax Deductible?
Generally, discount points could be deducted as mortgage interest on a primary home or one that is being rented out. However, the deductibility of mortgage points has restrictions which include:
- The money used to purchase the points must not be borrowed and must be paid directly to the lender.
- The mortgage obtained must be used to build, buy, or improve the home. The home will act as the security for the loan.
- Origination points on non-rental properties are not tax-deductible.
- Paying points to refinance a mortgage could mean spreading out the tax deduction over the loan term.
Points for Adjustable Rate Mortgages (ARMs)
Points for an adjustable-rate mortgage offer a discount on the interest rate of the loan during the first fixed-rate period which is also referred to as the teaser rate. You should run the numbers to ensure that you hit your break-even point before the fixed-rate period ends.
Just like purchasing products and services, buying a home is a vital financial decision that requires careful consideration. It pays to plan carefully and determine the best way to get the payment whether it is by paying discount points or making a huge down payment. If you want to know what are points on a mortgage and how to calculate your mortgage payment, be sure to speak to a financial advisor. There are also numerous services online that can help you determine how much loan you can get as well as the interest and monthly payments you will be required to make.
Guttentag, J., The Mortgage Encyclopedia, McGraw Hill, New York, NY
Talamo, J., The Mortgage Answer Book, Sphinx Publishing, Naperville, IL