Here's What Happens When You Pay Points on a Mortgage

It's gotten pretty expensive to sign a mortgage loan these days. As of late June, the average mortgage rate for a 30-year fixed loan was 6.67%, according to Freddie Mac. And the higher your rate, the more your mortgage is apt to cost you over time in the form of interest payments.

The good news, though, is that there's a step you can take to lower your mortgage's interest rate. It'll cost you some money upfront, but it may be worth it.

How paying points on a mortgage works

Many lenders allow borrowers to pay points on their mortgages to lower their loans' interest rates. And this is a move that could make sense if you expect to be in your home for a long time. If you're buying a starter home you only anticipate living in for a few years, it may not be worth it.

When you buy mortgage points, each point costs 1% of the amount of your loan. So if you're borrowing $200,000, one point will cost you $2,000. And that point will, in turn, generally reduce the interest rate on your loan by 0.25%.

Now, the downside of paying points is having to fork over money upfront. The upside is that you might save yourself a lot of money in the course of paying off your home.

Let's say you're borrowing $200,000 at a fixed rate of 6.5% over 30 years. All told, that will have you paying $255,280 in interest.

Now, let's say you buy down your rate by paying for two mortgage points. It'll cost you $4,000 upfront, but it'll take the rate on your loan down to 6%. And assuming you're borrowing $200,000 over 30 years, that leaves you racking up a total of $231,677 of interest in the course of paying off your home.

When we run the numbers, this reads like a good deal. You're looking at saving $23,603 in interest by forking over $4,000 upfront. So all told, you're ahead $19,603.

You may be thinking, "But what if I don't buy down my mortgage rate and just invest my money instead?" The stock market has averaged a 10% annual return before inflation over the past 50 years, as measured by the S&P 500. So investing $4,000 at 10% over 30 years means gaining about $65,800. That could easily make the case for you not to buy points even if doing so saves you $19,603 in interest.

However, this assumes that a) you'll actually invest that money instead, and b) your portfolio will enjoy solid growth for many years. If you can admit that you likely will not invest your money, then paying points on your mortgage could make sense.

What if you plan to refinance?

You may be inclined not to buy points on your mortgage because you intend to refinance once interest rates drop. That logic makes sense, because if you're able to refinance in a year or two from now to a much lower rate, then you may not recoup enough interest in that short time frame to make up for the money you spent to buy points. So that's a risk.

However, we also don't know when mortgage rates will fall to the point where refinances will make sense. So you may want to consider paying points if that option is available to you.

Another thing you may be able to do is get your seller to buy down your rate for you. This tactic commonly works when a seller is desperate for a quick sale.

However, today's housing market sorely lacks inventory. So generally speaking, sellers may not be willing to pay down their buyers' rates. If that's the case, you'll need to decide if paying points is something that makes sense for you.