mortgages

What Are Mortgage Points and How Do They Work?

9 Minute Read

Buying a home? As you prepare for one of the most expensive purchases you’ll likely ever make, it’s smart to consider all the potential ways to save money. Mortgage points are one of those options.

But what are mortgage points and how do they work? Are they really a money-saving deal?

Types of Mortgage Points

There are two types of mortgage points. One type is origination points—which usually cost 1% of the loan amount. This point-based arrangement acts as compensation for all the work your loan originator (lender or broker) is going to do to get you a loan. But it’s possible to find a loan originator that doesn’t require you to pay origination points. Just make sure they’re not charging the fee in a different way, like through a higher interest rate. You’re better off paying out-of-pocket for their service and avoiding origination points altogether.

We’re going to focus on the second type, known as discount points. Lenders offer mortgage discount points as a way to lower your interest rate when you take out a mortgage loan. The price you pay for points directly affects the total interest of the loan. The more points you pay, the lower the interest rate. No kidding—that’s because you’re prepaying the interest. You’re just paying part of it at the beginning instead of paying it over the life of the loan.

How Do Mortgage Points Work?

After you apply for a mortgage, your lender will offer discount points as a way to lower your interest rate. Your point options will be listed on official home transaction documents like the Loan Estimate and Closing Disclosure. Most lenders allow you to purchase between one to three discount points.

To buy mortgage points, you pay your lender a one-time fee as part of your closing costs.

Before you shop for a house, get pre-approved.

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How Much Does One Point Lower Your Interest Rate?

One mortgage point usually equals 1% of your total loan amount and will lower the interest rate of your mortgage around one-eighth to one-quarter of a percent. The actual percentage change will depend on your mortgage lender.

Let’s walk through an example. Suppose you’re buying a $300,000 house. You have a 20% down payment and are taking out a 30-year fixed-rate conventional loan of $240,000 at a 4.5% interest rate. To lower the interest rate, you pay your lender for one mortgage point at closing, and assuming that point equals 1% of your loan amount, it will cost $2,400.

$240,000 loan amount x 1% = $2,400 mortgage point payment

After you buy the mortgage point, your lender reduces the interest rate of your mortgage by, say, a quarter of a percent. That takes your interest rate from 4.5% to 4.25%. This slightly lowers your monthly payment from $1,562 to $1,526—which is $36 less a month on a fixed-rate conventional mortgage.

You can use a mortgage calculator to figure the difference between the interest amount with the original rate (4.5%) and the interest amount with the reduced rate (4.25%) over the life of the loan. Without any mortgage points, you’ll pay a total of $197,778 in interest. With one mortgage point, you’ll drop that amount to $185,035—which saves you $12,743 in interest.

$197,778 original total interest paid - $185,035 reduced total interest paid = $12,743 amount saved

But when you account for the $2,400 you paid for the mortgage point, you really only saved $10,343.

$12,743 interest savings - $2,400 mortgage point = $10,343 true savings

This process is known as "buying down the rate." But remember, you’re really just prepaying interest. The more points you buy, the more interest you prepay—which is why your lender would be willing to lower the interest rate on your loan. Take a look at the chart below to see how this example plays out with two mortgage points.

30-year loan amount: $240,000 No Points 1 Mortgage Point 2 Mortgage Points
Cost of Point(s) N/A $2,400 $4,800
Interest Rate 4.5% 4.25% 4%
Monthly Payment $1,562 $1,526 $1,491
Monthly Savings N/A $36 $71
Total Interest Paid $197,778 $185,984 $172,486

Should You Pay for Mortgage Points?

It seems odd to say, but buying mortgage points to lower your interest rate could actually be a complete rip off. How can a lower interest rate be a bad deal? For starters, it could be years before you really save any money on interest because of your mortgage points. To see what this would look like for you, you’d first need to calculate what’s known as your "break-even" point.

What Is the Break-Even Point on a Mortgage?

The break-even point is when the interest you saved is equal to the amount you paid for mortgage points.

Let’s calculate the break-even point from our earlier example. To do this, just divide the cost of the mortgage point ($2,400) by the amount you’d be saving per month ($36). That answer is the break-even point.

$2,400 / $36 = 67 months (5 years and 7 months)

In other words, in 67 months you’d have saved over $2,400 in interest—the same amount you paid for the mortgage point. After reaching the break-even point, you’ll pocket that $36 each month, which will be the money you save on interest because of the mortgage point you bought.

Are Mortgage Points Worth It?

Mortgage points could be worth it if you actually reach your break-even point—but that doesn’t always happen.

According to the National Association of Realtors’ 2018 report, the median number of years a seller remained in their home was 10, the same as last year. From 1985 to 2008, NAR reports the tenure in a home was six years or less.(1)

While 10 years is enough time to break-even in our example, most buyers won’t regain their money on mortgage points because they usually refinance, pay off, or sell their homes before they reach their break-even point.

While 10 years is enough time to break-even in our example, most buyers won’t regain their money on mortgage points because they usually refinance, pay off, or sell their homes before they reach their break-even point.

Instead of buying mortgage points, put that extra money toward your down payment and reduce your loan amount altogether. Ding, ding!

An even better way to lower your interest rate without taking the risk of mortgage points is to shorten the length of your loan from a 30-year fixed-rate conventional loan to a 15-year one, which is the type we recommend.

If your estimated interest rate still looks too high, get a real estate agent who can help you find a house that’s actually within your budget.

Beware of Adjustable-Rate Mortgage Points

If you’re considering getting an adjustable rate mortgage (ARM) loan, don’t do it! ARM loans are one of the top mortgages to avoid because they allow lenders to adjust the rate which transfers the risk of rising interest rates (and monthly payments) to you. Seriously, these things are terrible.

And that’s not all. If you buy mortgage points on an ARM loan, lenders might only provide a discount on the interest rate during the initial fixed-rate period. Once the fixed-rate period expires, you lose your discount, which could happen before you even reach the break-even period. That’s a win for the bank—not for you.

Do Mortgage Points Affect Taxes?

Mortgage points may be tax deductible as home mortgage interest—but that still doesn’t make them worth buying. In order to qualify, the loan must meet a slew of qualifications on a lengthy list of bullet points, all of which are determined by the IRS.(2) If you’ve already bought mortgage points, at least check with a tax advisor to make sure you qualify to receive those tax benefits.

Get a Smart Mortgage

Your house may be the biggest purchase you’ll ever make. You don’t want to mess this up. The right lender can help you feel confident about your mortgage and save you thousands!

If you’re looking for a lender who will help you understand the ins and outs of mortgage points so you can make the best decision for your budget, contact our friends at Churchill Mortgage. They’ve helped thousands of people like you understand and finance their home the smart way.

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