There are a wide range of ways that a borrower can customize a loan to suit their needs, ranging from the type of loan itself, loan repayment terms, or fixed or adjustable rates. Another significant way that the loan can be customized is to purchase “mortgage points”, also known as “discount points.”
Mortgage points are a tool that allows a borrower the ability to influence your monthly payments, the interest rate on your loan, and, ultimately, the overall cost of your mortgage. Here we will examine how mortgage points work, how to calculate a “break-even” point to make an informed decision and even look at scenarios where it is wise – or not – to buy mortgage points.
What are Mortgage Points?
Mortgage points, often called "discount points," allow a borrower on a mortgage to take an upfront cost in exchange for a reduced interest rate on their loan. A single mortgage point typically costs 1% of the total loan amount. For example, one point on a $200,000 loan would cost $2,000.
When the term “points” is used, it is typically referring to one of two types:
- Discount Points – These are the points we’ll focus on here. By paying discount points upfront, you lower your interest rate for the life of the loan.
- Origination Points – These are costs charged by the mortgage lender to cover the cost of processing and underwriting the loan. While similar in structure to discount points, origination points are not specifically for the purpose of lowering your interest rate.
Mortgage points are often used to reduce your mortgage interest rate, but they have a cost that should be carefully weighed. The higher the loan amount and the longer the loan term, the more beneficial buying mortgage points can become, if done under the right circumstances.
How DO Mortgage Points Work?
Mortgage points work by lowering your interest rate in exchange for an upfront payment. The degree to which the interest rate is reduced depends on several factors, varying between the lender and loan type. As a typical frame of reference, one point will reduce the interest rate by about 0.25%.
For example, if a homeowner is offered a mortgage with an interest rate that is 6.5%, and you pay one point (1% of the loan amount), this discount point would drop the interest rate to a 6.25% mortgage interest rate. This reduction can lead to significant savings over the life of the loan, especially on larger loan amounts and longer terms. Here’s an example of how the math works:
- Loan amount: $400,000
- Interest rate: 6.5% before points
- Loan term: 30 years
- Monthly payment: $2,528.27 (excluding taxes and insurance)
By purchasing one point for $4,000, the interest rate would instead be 6.25%, resulting in a lower monthly payment of $2,462.87.
Over the course of the 30-year loan, the reduction in monthly payments adds up to significant savings, but that initial $4,000 paid for the point will need to be recouped over time. As we will discuss shortly, determining whether it is to your benefit to purchase points involves how quickly the initial cost is recouped, and whether your situation involves adequate time to offset that cost in order to realize both a monthly savings and a savings over the amount of time you will be repaying the loan.
Benefits of Buying Mortgage Points
Lower Monthly Payments: The most immediate benefit of buying mortgage points is a reduction in your monthly payment. This is particularly helpful for homeowners who are looking to lower their monthly financial burden, especially if they expect to stay in their home for a long time.
Long-Term Savings: While you’ll pay more upfront, the interest savings over the course of the loan can be substantial. With a reduced interest rate, you’re paying less interest over the life of the loan. Especially over the span of a 30-year mortgage, these savings can often far outweigh the initial cost of buying the points.
Tax Benefits: In some cases, buying mortgage points may offer tax benefits. Since points are considered pre-paid interest, you may be able to deduct the cost of the points on your taxes. Given the complexity of tax rules, it is recommended that you consult with a tax professional to determine whether this applies to your situation.
How to Figure Out Your Break-Even Point
In addition to determining how your situation requires the balance between up-front costs and monthly payments, what is central to the decision of whether discount points are appropriate for you is when you will “break even” and reach a point of net savings. The break-even point for discount points is the moment when the savings you’ve accrued from your reduced monthly payments equals the amount you initially paid for those points. Essentially, this is when the investment in the points “pays for itself.”
To calculate your break-even point, you need to compare the upfront cost of the points with the monthly savings.
1. Determine the upfront cost for the points: For each point, you will pay 1% of the loan amount. If you were to buy two points, that would mean 2% of the loan amount.
2. Subtract the new, reduced monthly payment (after the interest rate reduction) from what would have been your monthly payment without any rate reduction. This calculation gives you your monthly savings.
3. Divide the total cost of the points by the monthly savings to get the number of months it will take to break even.
Example Scenario
Let’s consider a homeowner who is taking a 30-year loan of $200,000. The rate offered was 5.5%, but to reduce their rate by 0.25%, they would buy a mortgage discount point. This homeowner wants to reduce their interest rate by 0.5% and would purchase two discount points to do so. How quickly will the homeowner break even on the purchase of two points?
- Upfront cost of 2 points: $2,000 per point x 2 = $4,000
- If the monthly payment without rate reduction is $1,073.64 and reducing the rate 0.5% brings the payment down to $1013.37, the monthly savings is $1,073.64 - $1013.37 = $60.27
- The break-even point is $4,000 / $60.27 = approximately 66 months (5 years and 6 months)
In this example, it would take five and a half years on a 30-year mortgage to recoup the cost of the points. If this homeowner continued to pay on this loan without selling or refinancing, any point beyond this break-even point would result in a net savings.
When to Buy Mortgage Points
While buying mortgage points can be beneficial, it may not be the right choice for every situation. Based on what we have discussed about the break-even point, here are some scenarios where buying mortgage points may make sense:
Long-Term Homeownership: If you plan to stay in your home for many years and prefer to reduce the monthly burden of your mortgage payment, buying mortgage points can be appropriate. The longer you stay beyond the break-even point, the greater the savings on interest throughout the life of the loan.
Large Loan Amounts: The larger your mortgage, the more potential you have to save money by buying points. With a higher loan amount, even a small reduction in the interest rate can lead to pronounced monthly savings.
Stable Financial Position: If you have the extra cash available and can comfortably afford the upfront cost of the points, it might be worth investing in them. If the reduced monthly payments are crucial for your financial health, paying for points may be a suitable option.
When Not to Buy Mortgage Points
There are also situations where buying mortgage points may not be the best option:
Short-Term Homeownership: If you plan to sell your home or refinance it in the near future, there may not be adequate time to recoup the cost of the points. In this case, paying for points might not provide enough long-term savings to justify the upfront cost.
Tight Cash Flow: If spending the money on mortgage points weakens your financial safety net and risks straining your finances if other expenses come up outside of your mortgage, points may not be justifiable. While it is important to seek terms with a lower payment, depleting a large amount of savings may not be the right trade-off.
Low-Interest Rate Environment: If you’re already securing a mortgage in a low-interest-rate environment or intend to refinance again soon, buying points might not offer significant savings.
Short-Term Loan: If you're taking out a short-term loan such as a 10-year or 15-year mortgage, the interest rate is likely lower than a 30-year loan and buying points may not offer significant savings. It is also likely that with a shorter-term loan, your situation may be one where the focus is on paying down the loan more quickly rather than trying to reduce the monthly payment.
Discussing Mortgage Points
Mortgage points can be a valuable tool for borrowers looking to reduce their interest rate, maintain a lower monthly payment, and save money on interest costs over the long term. However, whether they make sense depends on your individual financial situation and goals, how long you plan to stay in your home, and whether you are well-positioned to purchase those points upfront.
By understanding the mechanics of mortgage points, calculating your break-even point, and evaluating your personal circumstances, you can make an informed decision about whether buying points is a smart move for you. Additionally, speaking with a reputable mortgage lender such as Union Home Mortgage is a great first step to find the right strategy and the right mortgage for your needs.
The information provided here is for informational purposes. When interest rates and loan program information are included, it is for illustration purposes only and not a solicitation or quote for services. This is not an advertisement or loan estimate. Current interest rates, loan programs and qualification criteria can change at any time. If you have questions or need assistance, we can be reached using the contact information above.
