What Are Mortgage Points and When Should You Buy Them?
Mortgage points, also known as loan discount points, are fees you pay upfront to reduce your mortgage’s interest rate. When you purchase a point, you essentially prepay the interest for a smaller monthly payment.
Some homeowners are averse to buying points. Others believe points make smart financial sense. So, who’s right?
Let’s dive into the ins and outs of mortgage points, how they work, and when it makes sense to buy them. By understanding the benefits and drawbacks, you’ll be able to make an informed decision that aligns with your situation.
Key Takeaways
Mortgage points allow you to lower your interest rate by paying an upfront fee.
Although similar, discount points and temporary buydowns aren’t the same.
The decision to buy points depends on factors such as your long-term plans for the home, your budget, and your financial goals.
Knowing the breakeven point is essential when deciding if buying points to lower your rate makes sense.
What Are Mortgage Points?
Buying mortgage points allows you to reduce your interest rate by paying some interest upfront as additional closing costs. This approach lowers your monthly mortgage payment and reduces the total interest paid over the life of the loan.
Some lenders use the word “points” to refer to any upfront fee calculated as a percentage of your loan amount, whether or not you receive a lower interest rate. But be careful not to confuse mortgage points with origination points, as the two are not the same.
Origination points are fees paid to your lender for originating your mortgage loan and are not connected to lowering your rate.
How Do Mortgage Points Work?
If you compare current interest rates offered by different mortgage lenders, you’ll typically see three numbers listed: the mortgage interest rate, the APR, and points.
Mortgage points are fees used to buy down your rate and are paid as part of your closing costs.
One point costs you 1% of your loan amount. Generally, each mortgage point lowers the interest rate by roughly 0.25%.
For example, if you have a $400,000 mortgage, one point would cost you $4,000 and might reduce your rate from 7% to 6.75%. However, how much each point lowers your rate can vary by lender.
There’s no set limit on the number of mortgage points you can buy. Typically, however, most lenders only let you buy up to three or four mortgage points.
Most lenders offer some flexibility in how many points you can buy and how much each point bought lowers your rate. Be sure to ask your lender how much each point will lower your rate and payment.
Discount Points vs. Buydowns
While discount points and buydowns are sometimes used interchangeably, they’re actually different.
Discount points are paid upfront in exchange for a permanent interest rate reduction, meaning your lower rate lasts for the entire term of the loan.
For example, if you paid two points on a 30-year fixed mortgage, you may reduce the interest rate by .5% for all 30 years, helping lower your monthly payment and save money over the life of the loan.
A temporary buydown, on the other hand, temporarily lowers the interest rate for the first few years of the mortgage.
The most popular buydowns are 3-2-1 and 2-1 structures. In a 3-2-1 buydown, for instance, the rate is lower by 3% in the first year, 2% in the second year, 1% in the third, and then reverts to the original rate for the remainder of the loan term.
While buydowns can make initial payments more affordable, they are temporary and don’t offer the long-term savings of discount points.
Discount Points and Adjustable-Rate Mortgages (ARMs)
For adjustable-rate mortgages (ARMs), mortgage points work similarly to fixed-rate loans.
The main difference is that the rate on your ARM adjusts after the initial fixed period. For this reason, it’s crucial to know how long you’ll be in the loan before buying points on an ARM.
Most argue that paying points when getting an ARM rarely makes sense. This is because it typically takes between five and seven years to recoup the costs of buying down your rate.
For example, let’s say you opted for a 5/1 ARM, knowing you’ll sell or refinance your home within the first three to four years. Doing so means you’ll unlikely recoup the costs of buying points before selling or refinancing.
If you have an ARM with a longer initial fixed-rate period (e.g., a 7/1 or 10/1 ARM), discount points can make sense, giving you a reduced interest rate for a longer time before the rate adjustments begin or before you sell or refinance.
A final key note about mortgage points and ARMs is that points for ARMs usually provide a discount on the loan’s interest rate only during the initial fixed-rate period.
Do Points Carry Over After a Refinance?
No, mortgage discount points do not carry over if you refinance. Discount points are a one-time upfront payment that applies only to the original loan for which they were purchased.
When you refinance, you’re essentially resetting the terms and conditions of your mortgage. Any points paid on the previous loan are not transferred to the new loan.
If you want to reduce the interest rate on the refinanced loan, you need to buy new discount points when refinancing. This is particularly important for those considering a “marry the home, date the rate” strategy, where they purchase now intending to refinance later.
If you plan to refinance soon, buying points may not be worth the upfront cost.
Are Points Allowed on Government-Backed Mortgages?
Yes, points are generally allowed on government-backed mortgages, including VA, FHA, and USDA loans. However, the structure and benefits of points may differ slightly depending on the loan program.
For instance, VA loans often have limitations on closing costs, so it’s important to consult your lender for specific details when buying points on a government-backed mortgage.
How Much Can Points Save You?
It’s important to bear in mind that the amount you can save by purchasing points varies based on factors like the lender, loan amount, interest rate, and the number of points bought.
Before diving into the calculations, keep one core principle in mind: the longer you stay in the same home with the same mortgage, the more you’ll benefit from a reduced interest rate. If you sell or refinance too soon, you might not recover the cost of the points.
To crunch the numbers, start by determining the difference in monthly payments with and without points. Then, divide the cost of the points by the monthly savings. The result tells you how many months it takes to break even on your investment in points.
Suppose you’re getting a $400,000 mortgage with a 6.5% interest rate. Buying one point for $4,000 might reduce the rate to 6.25%, saving you about $65 per month on your payment. Over the life of a 30-year loan, this results in a savings of $23,400 in interest.
In another scenario, if you buy two points for $8,000 and reduce your rate by 0.50%, your monthly savings might be closer to $130, saving you a total of $46,800 in interest over the life of the loan. In this case, buying points becomes more appealing if you plan to stay in the home long enough to recoup the initial cost.
Pros and Cons of Discount Points
Pros
Lower monthly payment: Discount points reduce your interest rate, which lowers your monthly mortgage payment.
Long-term savings: If you plan to stay in the home long term, points can save you thousands in interest.
Tax deduction: In some cases, such as itemizing your tax deductions, points may be tax-deductible as mortgage interest.
Cons
Higher upfront cost: Buying points can sometimes mean paying significantly more in closing costs.
Takes a while to break even: Points may not be worthwhile if you plan to sell or refinance soon.
Not always the most effective investment: Sometimes, it may be a better use of your available funds to make a larger downpayment.
Who Is a Good Candidate for Mortgage Points?
Mortgage points may be a good option for homeowners who plan to stay in their homes for an extended period.
However, mortgage borrowers planning to move or refinance within a few years might find the upfront cost outweighs the potential benefits.
When to Buy Mortgage Points
It’s a good idea to consider mortgage points if:
You have extra funds available at closing and want to reduce your monthly payment.
You plan to stay in the home long enough to reach the breakeven point and benefit from the long-term savings.
You are securing a fixed-rate mortgage, where the benefits of points last the entire term of the loan.
When Not to Buy Mortgage Points
Mortgage points might not be ideal if:
You’re short on cash at closing and need to keep upfront costs low.
You plan to move, sell, or refinance within a few years.
You’re getting an adjustable-rate mortgage (ARM), where points only apply to the initial fixed-rate period.
The Breakeven Point
The breakeven point is a crucial factor when deciding whether to buy points. To find the breakeven point, simply divide the cost of the points by the monthly savings they provide.
For example, if you paid $3,500 for one point and saved $50 per month, the breakeven point would be 70 months or about 5.8 years. If you plan to stay in the home for roughly six years or more, buying points may be worthwhile.
Using the same example, if you only stayed in the home for 5 years, you’d miss your breakeven point by 10 months, resulting in a loss of $500. So, if you’re unsure about your long-term plans, it may be better to forgo the points.
Our Take on Mortgage Points
While mortgage points can offer significant long-term savings, they’re not suitable for every homeowner. Some financial experts caution that buying points is often a gamble, especially if you’re uncertain about how long you’ll stay in the home.
Given the upfront costs, it’s important to carefully evaluate your long-term plans and financial goals. If you anticipate moving or refinancing soon, the upfront cost of points may not be worth it.
For long-term homeowners, however, the math is hard to dispute. Mortgage points can be a valuable investment in lowering monthly payments and long-term savings.
