A Guide to Understanding and Managing Mortgage Points

Mr A

What Are Mortgage Points?

Mortgage points, also known as discount points or simply points, are a type of prepaid interest on a mortgage loan. Lenders offer borrowers the chance to pay for points upfront in exchange for a reduced interest rate over the life of the mortgage. Understanding how mortgage points work and when it makes sense to purchase them can be crucial in lowering your overall mortgage cost.

There are two types of mortgage points:

1. Discount points: These points are bought by the borrower to reduce the interest rate on the mortgage loan, thereby reducing the monthly payment. The general rule of thumb states that one point costs 1% of your mortgage amount and will lower your interest rate by about 0.25%.

2. Origination points: These are fees charged by the lender or broker for processing the loan application and are not related to reducing your interest rate. Origination points vary among lenders, and it may be possible to negotiate these fees or work with a lender who charges fewer points.

How Mortgage Points Affect Your Mortgage Payments

When considering mortgage points, it's important to understand how they impact your mortgage payments, the amount of interest you will pay, and your overall loan cost.

Monthly Payments - When you purchase discount points, your monthly mortgage payment decreases, as the lower interest rate reduces the amount of interest you owe each month. This decrease in payment can be attractive to borrowers who want a more affordable monthly payment.

Interest Paid - Over the life of the loan, a lower interest rate can save you a significant amount of money in interest payments. This can make purchasing discount points a wise long-term investment.

Loan Cost - Discount points increase the upfront cost of the mortgage, as the borrower pays for them at closing. However, the resulting lower interest rate can ultimately save you money over time, which makes discount points a potential means to reduce your overall loan cost.

It's essential to calculate and compare the total cost of your mortgage with and without discount points to determine if buying points is a good deal for you.

When Mortgage Points Make Sense

The decision of whether to purchase mortgage points depends on several factors, including your financial situation, the length of time you plan to stay in your home, and your goals for your mortgage.

Long-term homeownership: If you plan to stay in your home for a long time, paying mortgage points may make sense because you will have more time to recoup the upfront cost through savings on interest payments.
Lower monthly payments: If you can afford the initial cost of discount points and desire a lower monthly payment, purchasing mortgage points may be a good option.
Interest rate and point combination: Analyze the specific interest rate and point combination to ensure the points' cost will result in savings that are significant enough to justify the upfront expense.
Tax benefits: Discount points may offer tax benefits, as they are usually tax-deductible as mortgage interest. However, it's crucial to consult with a tax professional to determine how this could apply to your unique situation.

When Mortgage Points May Not Make Sense

In certain scenarios, purchasing mortgage points may not be a wise decision.

Short-term homeownership: If you plan to sell your home or refinance your mortgage in a few years, you may not have enough time to recoup the upfront cost of mortgage points before realizing the savings from the lower interest rate.
Lack of funds: Paying for points at closing can be costly. If you don't have enough funds or could use that money for a larger down payment, home improvements, or other expenses, it might be best to skip mortgage points.
Low interest rate environment: If interest rates are already low, purchasing mortgage points may not result in a significant enough reduction in the rate or savings to justify the upfront cost.

How to Determine If Mortgage Points Are Worth It

To decide if mortgage points are worth the expense, you'll need to do some math by calculating your break-even point - the point at which the savings from the lower interest rate surpass the upfront cost of the mortgage points.

Follow these steps to calculate the break-even point:

1. Determine the cost of the mortgage points: Multiply your loan amount by the number of points (expressed as a percentage). For example, if your loan amount is $200,000 and you want to buy 1 point, the cost will be $2,000.
2. Calculate your new monthly payment without mortgage points and with mortgage points by using a mortgage calculator.
3. Subtract the new monthly payment (with points) from the original monthly payment (without points) to find your monthly savings.
4. Divide the cost of the mortgage points by the monthly savings to find the number of months to break even. For example, if the mortgage points cost $2,000 and your monthly savings are $50, you would break even after 40 months ($2,000 / $50 = 40).

If the break-even point is less than the number of months you plan to stay in your home, mortgage points may be worth the investment. If the break-even point is longer than the time you plan to live in the home, it might be better to forego the points.

How to Shop for Mortgage Points

When shopping for mortgage points, consider the following steps:

1. Obtain loan estimates from multiple lenders: Request loan estimates from different lenders, specifying the number of points you want to purchase. This will help you compare loan offers and find the best deal.
2. Compare interest rates and points: Look for the best combination of interest rate reductions and point costs. Some lenders may offer a larger rate reduction for each point purchased, which could make buying points more valuable.
3. Negotiate with lenders: Use the loan estimates to negotiate with lenders for better terms and rates. You may be able to negotiate a lower rate without paying for points or reduce the cost of the points themselves.
4. Assess the potential tax benefits: Speak with a tax professional to understand the tax implications and benefits of purchasing mortgage points.

Conclusion

Understanding and managing mortgage points can be an essential step in reducing your overall mortgage cost. Before deciding to purchase points, assess your financial situation, goals, and the current interest rate environment. Calculate your break-even point and compare options to ensure that mortgage points are worth the investment for your unique circumstances. Lastly, shop and negotiate with lenders to find the best combination of interest rate reductions and point costs for your mortgage loan.