What are mortgage points? You need to answer this question before you apply for a mortgage.
Mortgage points, or discount points, are upfront fees you pay your lender to reduce -- or buy down -- your mortgage rate. When you lower your interest rate, you lower both your monthly mortgage payment and total interest costs over the life of the loan.
Buying points can make sense for many home-buyers, but you need to consider how long it will take you to break even on the initial fees you pay per point.
If you don't plan to stay in your home long enough for your reduced interest rate to cover the cost of the mortgage points you paid for, it doesn't make sense to pay points. However, if you plan to stay in your home for a long time, you'll often end up saving more on interest than the points cost to buy.
When you buy mortgage discount points, you pay a specific amount of money to your lender in exchange for an interest rate reduction. Typically, each point you buy costs 1% of the total loan amount. If you're borrowing $200,000, you'd pay $2,000 for one point.
Each point you buy generally reduces your interest rate by 0.25%. For example your interest rate might go from 3.00% to 2.75% if you paid for one point. However, the specific amount your interest rate is reduced will vary depending upon your lender and loan program.
If paying 1% of your mortgage to buy a point seems unaffordable, your lender may also allow you to buy half-points. These obviously cost less, but also reduce your interest rate by less. Buying half a point would cost you 0.5% of the loan amount and would reduce your interest rate by 0.125%.
When you buy points on your mortgage, it's considered to be “prepaying interest.” As a result, you are typically able to deduct the amount you paid for the points from your federal taxable income.
However, the amount you're allowed to deduct will vary based on how much your mortgage is. In some cases you might be borrowing too much money to fall within the IRS limits. In this case, your mortgage is not fully tax deductible and you'll only be able to take a partial deduction.
For all mortgages obtained after December 15, 2017, the maximum loan value in order for interest to be fully deductible is $750,000. If you borrow more than this amount, you'll only be eligible for a partial deduction.
The IRS also indicates you must meet certain requirements to take either a full or partial deduction for the mortgage points you buy. You can deduct points in the tax year they are paid if:
Once you answer the question, what are mortgage points, that's just the start. You need to do some math to see when you would break even from the purchase. For example, say you were taking out a $250,000 loan. You have a choice between not buying points and getting an interest rate of 3.00% or buying one point and reducing your rate to 2.75%. If you take a 30-year mortgage and remain in your home the entire time, you'd obviously end up better off for having paid points.
You'd pay $2,500 for a point (1% of $250,000) and would save $12,027 over time. But if you plan to sell or refinance, you may not be in your home long enough for your monthly savings to make up for the $2,500 you spend.
You can calculate roughly how long it will take you to break even for paying points. Simply divide the cost of the point by the monthly savings. For example, if you divide $2,500 by $33, you'd see it would take around 75 months for the savings to cover the upfront cost of buying mortgage points.
Of course, this doesn't take into account the difference in how quickly your mortgage is paid down at the different interest rates. Since a lower rate means you pay off principal a little faster, you'd have a slightly lower mortgage balance if you refinance or move soon after buying points. For example, after one year:
This also helps offset some of the cost of the point too. If you don't want to go into this extra math, you can still get a rough idea with the simpler calculation above. But if you'd prefer to know exactly how long it would take to break even, you'll need to use an amortization calculator to determine the difference in the two loan balances and take that into account when deciding whether buying a point makes sense for you.
Knowing exactly what are mortgage points means you can decide whether it makes sense to buy points. You can also make certain you're comparing apples-to-apples when you take out a mortgage loan.
When you shop around the best mortgage lenders, let's say one lender offers you a loan at 3.00% with no points and the other offers you a 3.00% loan but charges you one point to get that rate. Obviously the first loan is a much better deal. With the second lender, you'd be paying 1% of the entire cost of your mortgage just to get the same rate the first lender is giving you for free.
You also have the option with some lenders to apply negative points to your mortgage. Essentially, this means you increase your interest rate in order to get a credit you can use to cover closing costs.
For example, if you were taking out a $250,000 mortgage and you applied a negative mortgage point, your interest rate might rise from 3.00% to 3.25% -- but you would get a $2,500 credit to cover costs at closing.
While negative points make your home cost more over time, they can sometimes make it possible to afford to close on a home when you otherwise would be tight on cash. Just be aware that it's a costly option.
In the above example where you raised your rate from 3.00% to 3.25%, your $250,000 loan would result in a monthly payment of $1,088 and the total cost of your mortgage would be $391,686.
Compare that with a monthly payment of $1,054 and a total cost of $379,444 if you hadn't applied negative points. You'd pay $34 more each month and $12,242 more over 30 years in exchange for having gotten $2,500 up front.
Whether you consider buying mortgage points to reduce your rate or applying negative points to get cash up front, make sure to do the math to understand the long-term impact your choice will have on your mortgage costs.
Your mortgage is probably going to be your largest debt with the biggest monthly payment, so you owe it to yourself to get the best deal possible.
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