Your mortgage rate drastically affects what you pay in interest over the life of your loan.
There are ways to lower your interest rate, such as improving your credit score or lowering your debt-to-income ratio. Another option is to buy mortgage points to secure a better rate.
While this may sound great on the surface, the process can be confusing, and it isn’t always the best deal for everyone. We’ll explain what you need to know about mortgage points and whether it’s the right option for you.
What Are Mortgage Points?
Your lender may offer the chance to buy mortgage points (also known as discount points) when you take out a mortgage on a house or refinance your existing home loan. This is essentially when you pay interest upfront to the lender. By doing so, you can lock in a lower rate for the life of the loan.
In general, each point costs 1% of the total mortgage amount and knocks 0.25% off the interest rate.
For example, if you take out a $200,000 mortgage and purchase one point for $2,000, you could lower a 4.25% interest rate to 4.00%. Your monthly mortgage payment would decrease from $983 to $954, a savings of $29 per month. Since you paid $2,000 that led to a savings of $29/month, you can calculate that it would take almost 69 months (five years and nine months) to break even. Over the full length of a 30-year mortgage, you would save over $10,000 in interest.
The more points you buy, the more you can save. It’s up to the lender to decide how many points a borrower can purchase, which may depend on the type of loan you secure and the current mortgage market conditions. Any points you pay for are listed on your Loan Estimate and itemized on the Closing Disclosure. You officially pay the points when you close on your new home.
Deciding Whether to Buy Points
Length of Time in Your New Home: Mortgage points make the most sense if you plan to live in your home for a long time. After all, the money you spend on a mortgage point could be earning you interest if you invest it. Just a 2% return is $40/year, pushing your break-even point out to just over 77 months, or six years and five months. If you plan to stay in your home longer than this, buying points might still make sense.
Down Payment Amount: Do some calculations to determine which option garners the greatest savings in your situation — paying for mortgage points or making a higher down payment. If you put less than 20% down, you could be required to pay private mortgage insurance (PMI). This typically costs between 0.5% and 1% of the total loan amount per year, potentially negating the benefit of buying points.
Your PMI will phase out after building up 20% equity in the house, eliminating your PMI payments and potentially lowering your interest rate. This applies to conventional loans, however if you obtain an FHA loan, the only way to drop PMI is to refinance.
Remember, you can pay mortgage points when you refinance, so if you make a smaller down payment, waiting until then to purchase points could be advantageous. Make sure to ask your lender which loan type you are being offered so they can help you understand whether it’s a good fit.
Type of Home Loan: Mortgage points make the most sense when paired with a fixed-rate loan. With an adjustable-rate mortgage (ARM), your interest rate, and therefore your payment amount, changes over time. Buying points might still save you money on a loan that adjusts at seven or 10 years, but probably not at five years. Most buyers only get an ARM when they’re seeking temporary financing anyway.
Tax Deductibility: Points are deductible as mortgage interest on primary residences, second homes, and houses being rented out. Just keep these conditions in mind:
- The loan must be secured against your home, whether you’re purchasing, building, or renovating.
- You must buy points by paying the lender directly.
- If you purchase points when refinancing a mortgage, the deduction may need to be spread out over the entire loan term.
Contact a tax professional if you have any questions.
Paying mortgage points could be a great way to reduce housing costs. Do some calculations to help you decide if it’s worthwhile in your situation. If you need help, our team can assist you.