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Understanding Mortgage Points

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4 illustrated houses--green, blue, yellow, red--with question marks about mortgage points

Mortgage points are fees paid with your the closing costs on your home loan to lower your mortgage loan interest rate. In other words, they’re a fee you pay upfront to reduce your costs long-term. A lower interest rate not only lowers your payment but lowers your total cost of the loan over its life.

Here’s a primer on mortgage points and how to use them.

What Are Mortgage Points?

Mortgage points are also called discount points and are paid to lower your mortgage loan interest rate. This process is called buying down the rate.

Typically, one mortgage point is equivalent to 1% of the loan amount. So, on a $200,000 loan, for example, one point equals $2,000. Discount points refer to prepaid interest, as purchasing one point can lower the interest rate on your mortgage interest rate from .125% to 0.25%. The amount of discount will vary by lender, so it’s worth shopping around.

You can buy partial points. For example, you can buy a quarter point or a half point as well as one-and one-quarter points and so on.

Origination points are another type of mortgage point. Origination points though are used to compensate loan officers and aren’t as common and are up for negotiation.

This article focuses on discount points.

Why Is It Important to Understand Mortgage Discount Points?

Many borrowers mistakenly believe some lenders charge points and other lenders don’t. Some also believe that when they pay no points, they’re getting something for free, but that’s not true.

Virtually all lenders offer multiple different rates and fees for every loan. They may not tell you about them all, but they exist.

Here’s a mortgage points example based on a $200,000 loan.

One point costs $2,000. That point drops the APR from 4.5% to 4.25%. That lower interest rate results in a monthly mortgage payment of $983.88—a monthly savings of $29.49.

Over the life of a 30-year fixed-rate loan, you’ll save $10,764. And the break-even point—or the time to recover the $2,000 cost of your point—is 68 months or five years 8 months.

When working with a loan representative, ask about paying points. The mortgage lender may not tell you about the option, so always ask. And ask before you get to the point of locking in your interest rate. If your lender won’t discuss points, consider finding a more cooperative lender who’s willing to work with you.

How to Calculate Points on a Mortgage

Start out by assuming that you won’t pay points unless you find it’s to your advantage and won’t cause financial issues. The trick is to find out how quickly you’ll get your money back.

Here’s a sample of savings on the interest rate for a 200,000 loan at a 30-year fixed-rate mortgage. Each point is worth .25 percentage point reduction in the interest rate and costs $1,000. That cost is likely higher, but we’ve used a nice round $1,000 for simplicity in the math.

Mortgage Rate without Points APR with Points Points Purchased Savings on Monthly Payment Breakeven in Months
6% 6% 0 $0 n/a
6% 5.875% .5 $16.03 31
6% 5.75% 1 $31.96 31
6% 5.625% 1.5 $47.79 31
6% 5.5% 2 $63.52 31

 

Note: The values in the chart serve only as an example to describe the concept and don’t reflect the rates and points you should expect from your lender. Rates and points fluctuate as market conditions change over time.

Look at the first two alternatives in the chart. You can see that the rate is one-eighth of a percent lower (6-5.875 = .125 = 1/8) for each one-half point you pay upfront. If you pay one full point, you get a rate that’s one-quarter percent lower. That may not sound like much, but on a $200,000 loan, the one-eighth percent reduces the annual interest cost by $192.24.

Over the life of the loan, you save $5,767.20. To buy that one-eight point, you may pay $1,000 (although likely you’d pay less). That’s a pretty good return on your investment—roughly 577%.

Leave that $1,000 in the bank, and what interest rate will you earn? A 3% return on a savings account would be really good and higher than today’s rates. Leave that $1,000 in the bank for 30 years and at a 3% interest rate compounded monthly, you’d have just $2,456.94. Note that with that reduction in interest from the point you purchased, it will take only 31 months to get your $1,000 back—a 2 year 7 month break-even period.

The good news is that you’ll continue to save that $192.24 every year once you break even. If you plan on staying in your home for 10 years, for example, your savings top $1,153. And of course, your home will likely be more than $200,000 when you decide to sell it, so your savings will be even greater.

Ask your loan representative or mortgage broker to make a little chart similar to the one above so you know which alternative is best for you to save money. If they won’t calculate the break-even period for you, be sure to get the rate sheet so you can do it yourself, or with your loan representative’s help.

Keep the rate sheet as you’ll want to refer to it and compare it with the rate sheet on the day that you lock in your rate.

Finally, some lenders or brokers might simplify the calculation for you in the following manner: On your $200,000 loan, 1.5 points cost $3,000 and reduce your monthly mortgage payment by $33. Divide 3,000 by 33 and you get 91 months, or 7.6 years, that you have to wait to break even.

This is just a rough estimate. The calculation is not that simple. An accurate break-even calculation must include points, monthly payments, the interest earnings on both the points and the monthly payments using the borrower’s investment rate, tax savings and the reduction in the loan balance.

Are Mortgage Points Deductible?

The IRS typically allows a homeowner to deduct the total amount of their points during the same year that the homeowner made the payments. However, if your home exceeds $1 million, then there is a limit to the deduction amount. The same also applies if you have more than $100,000 in equity in your home.

Other requirements for this tax deduction include the following:

  • The residence you paid the points on must be your primary residence and not an investment property or second home
  • The points have to be a percentage of the total mortgage
  • You can’t purchase points with borrowed funds

If you find that you can’t deduct the points during the current tax year, you can consider deducting them over the life of the loan term.

To deduct your points, your lender will have to send you a Form 1098. You’ll need to file using Form 1040, Schedule A. Sometimes deducting points and having to itemize your deductions can be a confusing and complicated process. You may benefit from the services and advice of a professional tax preparer.

Your Mortgage Interest Rate and Your Credit Score

Remember, taking out a mortgage can have a significant effect on your credit. And your credit score can have a significant impact on your mortgage and the interest rate you’ll pay. A good credit score can lower your interest rate as much as buying points. So, before you start home shopping, get your free credit scores on Credit.com and find out where you stand.

This article was last published November 23, 2016, and has since been updated by another author.


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