For homebuyers taking out a mortgage, the interest rate on their loan is a major factor that influences the size of the monthly payment and how much they pay in total. One way to lower the interest rate is by paying points.
When you buy mortgage points, which are also known as discount points, you pay an upfront fee to the lender to reduce your interest rate. The difference in your rate depends on the individual lender, how many points you buy, the type of loan you have, and overall market conditions.
There are benefits and drawbacks to paying points, so it’s important to understand how points work before you decide. Here’s what you need to know about buying mortgage points:
- What Are Mortgage Points?
- Pros and Cons of Buying Points on a Mortgage
- Should You Buy Points on a Mortgage?
- Mortgage Points FAQ
- The Bottom Line on Mortgage Points
What Are Mortgage Points?
Mortgage points are an upfront lender fee that borrowers pay to get a lower interest rate on their home loan. Points increase the homebuyer’s closing costs because they’re paying more money upfront. At the same time, points make the monthly mortgage payment less expensive and reduce the total amount of interest paid over the life of the loan.
How do mortgage points work?
Every point you buy costs 1% of your loan amount.
So, if you have a $300,000 mortgage, then 1 point would equal 1% of $300,000, which is $3,000. And 3 points would be 3% of $300,000, which is $9,000.
There also can be partial points on that $300,000 loan. For example, you could buy 1.575 points for $4,725, or 0.5 points for $1,500.
Lenders are required by law to provide a discounted interest rate if you pay points. This means a loan with 1 point must have a lower rate than the same type of loan with no points from the same lender.
However, every lender is different when it comes to pricing structures. You could pay points with one lender but wind up with a higher interest rate than if you paid no points with another lender. The actual reduction in your rate will vary depending on the lender you use, the type of loan you’re getting, and market conditions.
If you choose to purchase points, they will be listed on both your loan estimate and your closing disclosure on Page 2.
The inverse of points is called negative mortgage points, also known as lender credits, where you reduce your closing costs by increasing the interest rate on your loan.
Following the previous example, if you receive a lender credit of $3,000 — or negative 1 point — on a $300,000 mortgage, then you’re getting 1% of the loan amount to help cover closing costs. You’ll also get charged a higher interest rate compared to the same type of loan with no lender credits. This means you’ll pay more in total interest and have a higher monthly mortgage payment.
Pros and Cons of Buying Points on a Mortgage
Buying points can help borrowers lower their monthly payment and save money on interest in the long run. However, they also require paying more money for closing costs.
Before you make the call, be sure to review the pros and cons of buying mortgage points.
Benefits of buying mortgage points
There are perks to paying points. Here are some pros of the mortgage point system.
Get a lower interest rate
If your credit score is on the lower end, then you’ll likely receive a higher interest rate on your loan. One way to save on your rate is working to improve your credit before applying for a mortgage. But if you’re ready to buy a home now, then another way to reduce your rate is paying points.
Reduce your monthly payments
Getting a lower interest rate means having a smaller monthly mortgage payment, since interest is a basic component of the monthly payment. With housing costs taking up less room in your budget, you could save money faster or have the freedom to spend more on other important areas of your life.
Pay less over time
Locking in a lower interest rate allows you to reduce the overall cost of taking out the loan.
“A borrower that can afford to buy down the rate by paying discount points in the beginning of a mortgage term will benefit over the long run by paying a lower monthly payment,” says David Reischer, a real estate attorney and CEO at LegalAdvice.com in New York City.
Drawbacks of buying mortgage points
Buying mortgage points comes with downsides. Here are some cons of paying points.
The upfront cost of your mortgage is higher
Buying points requires paying more for your mortgage upfront, so your closing costs are more expensive. In general, closing costs already cost 2% to 5% of the home’s purchase price.If you can’t comfortably afford this bigger lump sum, then paying points might not be right for you.
Moving could prevent you from recouping the cost of points
Mortgage points can cost thousands of dollars, paid out of pocket all at once. Over time, the savings on your reduced interest rate will accumulate with each monthly payment.
Increasing your down payment could be more beneficial
If you have enough money to buy a bunch of points, then you could increase your down payment instead. After all, if you’re taking out a conventional loan and your down payment isn’t at least 20% of the home’s purchase price, then you’ll need to pay for private mortgage insurance — adding to your loan costs.
Generally, making a larger down payment also helps reduce your interest rate.
Should You Buy Points on a Mortgage?
Buying points is a trade-off. If you can cover the higher upfront cost, then you’ll get a lower rate, have smaller monthly payments, and pay less mortgage interest over time.
“When deciding whether to pay points, three things are important: how long you plan to keep your loan, how much money you have to pay closing costs, and how much you can afford to pay each month.”Alishea Pipkin, retail branch manager at Planet Home Lending in Shreveport, Louisiana
So, is it worth it to pay points on a mortgage? If you plan to refinance or pay off your mortgage early, then paying points might not be beneficial after all, according to Pipkin.
Reischer says that borrowers typically take four to six years to recoup the cost of buying points.
What is the break-even point?
The break-even point is the moment when your accumulated monthly savings on interest match the upfront cost of paying points. Once you pass the break-even point, you’ll begin to save money overall.
How much can you save on your monthly payment?
Let’s say you’re taking out a 30-year, fixed-rate mortgage for $400,000. Here’s how buying points can affect what you pay in this example:
How Discount Points Affect a 30-Year, Fixed-Rate Mortgage for $400,000
|Number of Points||Cost of Points||Interest Rate||Monthly Principal and Interest Payment||Total Savings After 30 Years||Break-Even Point|
|1 point||$4,000||4.25%||$1,968||$17,228||68 months|
|2 points||$8,000||4%||$1,910||$34,047||69 months|
|3 points||$12,000||3.75%||$1,852||$50,925||69 months|
Additionally, looking at a loan’s annual percentage rate can be a useful way to compare mortgage costs. APR represents the annual cost of borrowing money and factors in the loan’s interest rate, any discount points, and other charges from the lender.
Mortgage Points FAQ
Here are some commonly asked questions about points.
Your points may be tax deductible because they’re considered prepaid interest. However, certain conditions apply, so check with the IRS. For example, you’ll need to itemize your deductions, and you might be eligible to deduct all the points paid if you can deduct all of your mortgage interest.
While there isn’t an official limit on the number of points you can buy, there are federal and state laws that cap how much you can pay in closing costs. As a result, most lenders won’t let you purchase more than approximately 4 points.
The Bottom Line on Mortgage Points
Buying mortgage points can help borrowers reduce their interest rate and pay less each month and overall for their home loan. However, homebuyers planning to move or refinance soon might not have enough time to break even and begin saving money. Points also increase closing costs, so borrowers paying points need to be prepared for the higher upfront fees. Still, paying points can be an effective way to save — if the borrower has cash on hand and stays in their home for the long term.