Mortgage points, or discount points, are fees you pay your lender at closing in exchange for a better interest rate. This can lower your monthly mortgage payments and is also known as “buying down the rate.”
One point costs 1% of the total loan amount. If the amount of your loan is $150,000, one point would cost you $1,500 at the time of closing.
At first glance, the idea of paying more in closing costs may seem crazy, but there are some cases where mortgage discount points can save you a substantial amount over the life of your new mortgage. Let’s break down how mortgage points work to find out if they’re right for you.
How Mortgage Points Work
Mortgage discount points are all about playing the long game. Generally speaking, the longer you plan to own your home, the more points can help you save on interest over the life of the loan.
How Many Mortgage Points Can You Buy?
There’s no one set limit on how many mortgage points you can buy. However, you’ll rarely find a lender who will let you buy more than around four mortgage points.
The reason for this is that there are both federal and state limits regarding how much anyone can pay in closing cost on a mortgage. Because limits can change from state to state, the number of points you can buy may vary slightly.
You might be wondering what the average number of mortgage points is for a transaction. Here, we’ll take a look at a survey of lenders conducted weekly by Freddie Mac regarding mortgage rates. For about the last 5 years, the average number of points reported on a 30-year fixed conventional loan was between 0.5 – 0.6 points.
The Break-Even Period
When considering mortgage points, it’s important to calculate how long it would take to recoup the upfront costs of purchasing points. This is commonly referred to as the break-even period. To calculate the break-even period, divide the cost of the points by how much you’ll save on your monthly payment. This will give you the number of months it will take for the monthly payment savings to equal the upfront costs of buying points.
Mortgage Points Example
Let’s use a $150,000 loan as an example to illustrate how discount points work. You can use our amortization calculator to do your own comparisons based on different loan amounts and interest rates.
Hypothetical Loan Amount: $150,000 for 30 years
|Points||Cost at Closing||Interest Rate||Monthly Payment||Monthly Payment Savings||Break-Even Period||Payment Savings on 30-year Loan|
|1.25||$1,875||4.75%||$782.47||$21.85||7 years, 2 months||$7,866|
|2||$3,000||4.25%||$737.91||$66.41||3 years, 10 months||$23,907.60|
As you can see from the chart above, even though 1.75 points costs $2,625 up front, you will end up saving $15,944.40 over 30 years because of the lower interest rate. And even if you don’t stay in your home for 30 years, you’ll break even in about five years. So, in this example, if you’re planning on living in your home for more than the break-even period, mortgage discount points could be a money-saving option.
It’s important to note that the numbers in the above example are hypothetical. The rate given for a certain number of purchased mortgage points varies by lender. Additionally, these calculations don’t include property taxes and insurance.
When Are Mortgage Points Worth Buying?
While mortgage discount points are an excellent choice for some clients, they’re not right for everyone. To determine if mortgage points are right for you, there are two main questions to ask yourself.
How Long Do You Plan to Live in Your Home?
As mentioned in the example above, the length of time you stay in your home is one of the most important factors. If you’re a wandering soul and you only plan to live in your house for a few years, it’s probably a better decision to pay lower closing costs and higher monthly payments.
How Much Money Do You Have to Put Down at Closing?
Another aspect to consider is mortgage insurance. Mortgage insurance guidelines will depend on the type of loan you have (conventional, FHA, VA, etc.), but as an example, let’s take a look at conventional loans. If your down payment on a mortgage is under 20%, you’ll be required to pay private mortgage insurance (PMI), which might cost about 1% of the loan amount. In the case of a $150,000 house, this means the PMI will cost $1,500 a year or $125 a month.
This is important for clients who are on the fence between paying for mortgage discount points or a larger down payment. If it’s between discount points and boosting your down payment to 20% or over, you’ll want to choose the down payment most of the time. Always do the math and consider if your discount points are costing you more or less than your monthly PMI fees.
PMI rates do vary from lender to lender, so this is a question worth asking if you’re shopping for a conventional loan. Quicken Loans offers some of the lowest PMI rates out there.1
Mortgage Points FAQs
Now you know how points work. With that background, there are a few other questions that might come to mind if you’re looking at your mortgage options.
Do Mortgage Points Have Tax Benefits?
There are also tax benefits that come along with purchasing points. Points are considered prepaid interest, so they may be deductible as home mortgage interest, but you’ll to need to fill out Form 1040, Schedule A and itemize these deductions. There are certain restrictions to this.
If you closed on a new mortgage prior to December 15, 2017, you can deduct the interest on up to $1 million worth of mortgage debt if you’re a joint filer ($500,000 if married filing separately). After that date, debt limits were lowered to $750,000 or $375,000 if married and filing separately.
One thing to note is that instead of deducting all of the points paid on your mortgage in the tax year in which you bought them, you often have to deduct the cost of your points in equal installments over the life of your loan. There are exceptions to this, as well.
Check out Topic 504 – Home Mortgage Points from the IRS. You can also speak with a tax adviser about whether you qualify for a deduction and the appropriate way to handle it.
Is There a Standard Rate Reduction for Buying Points?
Lenders’ terms around the level of discount you would get for buying points varies, so there’s no standard reduction in rate. It would be a good idea to shop around.
How Do Points Work If I Have an Adjustable Rate Mortgage (ARM)?
The rate adjusts at the end of the fixed period on an ARM. However, any discount points you pay generally only apply to the initial fixed rate you get – also known as the teaser rate.
Are Discount Points and Origination Points the Same?
Discount points are specifically paid to lower your interest rate. Origination points are lender charges for giving you the loan. Although they both amount to a certain percentage of the loan, the fees are for different things.
Pro Tip: Save the Surplus
If you decide to purchase mortgage discount points, you should also consider investing the excess money that you save every month. Let’s say you decide to purchase 1.75 mortgage discount points on your $150,000 loan, meaning your monthly payment is $760.03. This means you’ll have a monthly savings of $44.29.
If you take that $44.29 and invest it month after month, then by the end of the 30-year period (assuming a 7% interest rate compounded annually), you will have $50,204.02. This far outweighs the initial $2,625 cost during the initial purchase of the points. Use this calculator to put in your own numbers.
Once again, this option is all about the timing. If you only have your home for 6 years, and you invest your excess funds during that time, you’ll only be getting about $3,800 out of your investment. At that ROI, you would be better off not paying for points at all and investing your initial $2,625. In the same seven years, this would produce a little over $4,200.
The Discount Point Decision
As you can see, there are a variety of factors that go into whether you should purchase discount points to buy down your interest rate. The good news is, you don’t have to crunch the numbers yourself. If you apply online through Rocket Mortgage® by Quicken Loans®, you can explore your options. One of our Home Loan Experts would also be happy to take your call at (888) 980-6716. You can also feel free to speak with a financial advisor in order to assess the best move for your personal financial profile. If you have any questions, you can leave them for us in the comments below.
1 BPMI monthly and LPMI single rate data is compared to publicly published private mortgage insurance rates.
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