There are various factors that impact your interest rate. To name just a few: the size of your down payment, your median FICO® Score, the term of your loan and how you plan to occupy the property. However, what doesn’t immediately come to mind for most people is the ability to pay to get a lower interest rate.
Within this post, we’ll discuss mortgage points – also referred to as discount points or simply points – and how to make comparisons when shopping for a mortgage. By the time you finish reading, you should have the tools to know whether buying points is right for you.
What Are Mortgage Points?
Mortgage points are prepaid interest. You pay for points at closing in exchange for a lower interest rate than you would otherwise get if you didn’t pay for the interest up front. One point is equal to 1% of the loan amount. If you were to pay for three points on a $100,000 mortgage, it would be $3,000 but three points on a $300,000 mortgage is $9,000, so the cost can add up quickly.
You have to do some math to determine whether you think the points will be worth it for you. However, it’s not too complicated, and we’ll break it all down in a minute.
When you’re considering buying points for a lower interest rate, it’s also important to note that you don’t have to pay for a full point to get a lower rate. Points are sold in increments all the way down to 0.125%.
The Mechanics Of Mortgage Points
When you consider mortgage points, you should know that you can pay for them to lower your interest rate, but your lender can also give you lender credits. This is when they take the money off your closing costs in exchange for you paying a higher rate over the life of the loan. The increments for the lender credits also start at 0.125% of your loan amount. If you’re looking to save on closing costs, this is what a lender is referring to when they talk about a rate that “pays back points.”
If you choose to pay for points to lower your interest rate, it’s important to calculate the breakeven point. Thankfully, this doesn’t require any crazy calculus. The formula is as follows:
Amount paid for points
Monthly payment without buying points – monthly payment with points
The result of that equation will give you the amount of time (in months) that it would take to break even on your investment and start saving money for the remainder of the life of your loan. If you do the math and you expect to be in the house for longer than that period of time, it could make sense to buy the points. If you expect to move before the breakeven point, you shouldn’t buy the points, or you should look at purchasing a smaller amount.
Mortgage Points Example
The easiest way to get a feel for this is to look at a quick example to understand how points work in practice. You can also play around with your own interest rates and loan terms using our amortization calculator.
For the purposes of our example, let’s assume you’re looking at a 30-year fixed loan of $300,000. The monthly payments below only look at principal and interest. Taxes and insurance will vary. Although we’ve attempted to make this example as realistic as possible, different lenders will give different interest rates for the same amount of points, so it’s worth shopping around.
|Points||Cost at Closing||Interest Rate||Monthly Payment||Monthly Payment Savings||Break-Even Period||Payment Savings on 30-year Loan|
|1.25||$3,750||4.75%||$1,564.94||$43.69||7 years, 2 months||$15,728.40|
|2||$6,000||4.25%||$1,475.82||$132.81||3 years, 10 months||$47,811.60|
How Many Mortgage Points Can You Buy?
Mortgage lenders don’t set specific limits on how many mortgage points you can buy. That said, there are federal and state guidelines around how much you can be charged to close a mortgage.
While nothing is hard and fast because state rules vary, regulations typically make it hard to purchase more than about four points.
Should You Buy Mortgage Points Or Make A Higher Down Payment?
Every situation is different, so we won’t get definite advice on the question of whether it’s more worth it to buy mortgage points or make a slightly higher down payment. Since both have the potential to lower your rate, we can go over some factors you should think about, though.
If you’re getting a conventional loan and are on the cusp of having a 20% down payment or equity amount in a refinance, it could make more sense to put whatever money you have toward the down payment rather than buying mortgage points. The reasoning behind this is that you don’t pay for private mortgage insurance (PMI) which can save you a monthly fee in the case of borrower-paid mortgage insurance (BPMI) and keep you from paying a higher rate with lender-paid mortgage insurance (LPMI).
If you’re not close to the 20% threshold, you should work closely with your mortgage lender to determine your options. Interest rates are bucketed based on your median FICO®score and occupancy– whether the property will be your primary home or a vacation or rental home, as well as the size of your down payment. A Home Loan Expert will be able to run the numbers to see if you save more money by paying for a certain number of points or making a slightly higher down payment.
Understanding The Impact Of Mortgage Points On Adjustable Rate Mortgages (ARMs)
With an ARM, you get an initial fixed rate that’s lower than what you would get for a fixed-rate loan with a comparable term at the beginning of the loan. This typically lasts 5, 7 or 10 years depending on the loan option you go with. The reason mortgage investors are willing to give you that initial rate at a bit of a deal is that the rate can then adjust up or down to match current market conditions, subject to certain caps on upward movement.
The investor has the advantage of not being asked to project inflation not so far in advance because the rate can change at the end of the fixed period. However, it’s important for anyone getting an ARM to note that the points they buy only apply to the initial interest rate, and not to any subsequent adjustments. So some of your point calculations may change if you have fewer years to break even and save money at that payment.
Comparing Mortgage Rates
When lenders set mortgage rates, you’re not always seeing the zero-point rate for advertising purposes. The rates shown often assume that you’ll be paying for a certain number of points. Lenders are required to disclose the assumptions they make in setting the rates they advertise. Points will be one of those disclosures, along with your median FICO® Score and loan-to-value ratio (LTV)– the inverse of your down payment or equity. For example, if you make a 3% down payment, you have a 97% LTV ratio.
One really easy way to get a feel for the overall cost of the loan is to look at the annual percentage rate (APR). For any loan you get, there will be two interest rates listed. One is the base interest rate you get based on factors like credit, LTV and occupancy. Next to that, there will be a higher rate. This is the APR and it factors in closing costs to come up with the total cost of the loan. The bigger the difference between the interest rate and APR, the more you can expect to pay in closing costs.
Discount points are just one of many factors that affect closing cost, but this does give you some sense of what you need to look for when shopping around. Pay attention to the assumptions associated with any advertised rate.
Now that you have a handle on mortgage points, you should feel that much more confident in your quest for home financing. Whether you’re looking to buy or refinance, you can get started online with Rocket Mortgage® by Quicken Loans® or give one of our Home Loan Experts a call at (800) 785-4788. If you have any questions for us, you can leave them in the comments below!
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