Paying Mortgage Points for a Lower Interest Rate
Paying mortgage points to get a lower rate on a mortgage is almost always a losing proposition. Most homeowners don’t keep their mortgages long enough to do more than recoup the up-front cost of paying points. A point is 1% of your loan amount. If you take out a $250,000 mortgage, 1 point equals $2,500.
Before we go any further, let’s look at why you would buy mortgage points and how you can use them. Mortgage points are also called discount points, and are essentially “points” you can buy during the mortgage process to help you get a lower interest rate. Each point you buy reduces your mortgage interest rate by a specified fraction of a percent, because you’re basically prepaying a portion of the interest on your loan. Pretty enticing, right? After all, you want to make sure your home loan is as affordable as possible, and mortgage points seem like a surefire way to save money over time.
While you can certainly save money by purchasing mortgage points, that’s not always the case. Sure, buying points lowers your interest rate by a small amount, but it can take a while for the savings to add up. Some lenders will do the math with you, showing you how much you’ll save over the 15 or 30 years of your mortgage, but what are the chances you’ll stay in your house for the entirety of your loan? Perhaps you’ll want to upgrade to a bigger house or a different neighborhood after a while, or you might face an unexpected move for work or family.
If for any reason you think you might sell before paying off your home loan, chances are you won’t reap the full benefits of the points you buy.
Types of Mortgage Points
Even knowing all that, this process can be confusing when you’re applying for a mortgage. Let’s break it down so it’s a little more clear. There are two types of mortgage points:
- Origination points are a fee you must pay a bank or mortgage company to give you a loan.
- Discount points (the focus of this story) lower the interest rate on your loan and reduce your monthly payments.
If your mortgage lender is requiring you to pay for points, they’re likely origination points. Ask your mortgage lender to clarify what these are so you fully understand what you’re getting for your money.
Origination points are an entirely different thing, though. What we’re talking about here when we say mortgage points are discount points.
As we mentioned above, borrowers get a lower rate for buying discount mortgage points because they’re prepaying a portion of the interest on their loan. Discount points are tax-deductible, just like the interest you pay with each monthly mortgage payment.
How Much Can Mortgage Points Lower Your Interest Rate?
A single mortgage point can lower your interest rate from somewhere between 1/8 to 1/4 of a percentage point. It’s absolutely critical to compare offers that include points to those that don’t, so you can calculate how much you’re really saving by paying thousands of extra dollars upfront to buy the points.
Some banks and mortgage companies actually promote interest rates that are only available by paying mortgage points. They hope you’ll be so wowed by a rate that looks like it’s lower than the competitors that you won’t notice the additional upfront cost.
The key question you need to ask is: How long will it take me to recoup what I spend on points through lower monthly mortgage payments?
Let’s compare two typical 30-year fixed-rate mortgages of $100,000 with the following specs:
- Mortgage Option 1: 4% interest rate with no mortgage points
- Mortgage Option 2: 3.875% interest rate with 1 point
Paying Mortgage Points vs Not Paying
|Loan||Terms||Monthly Payment||Total Payments Over 30 Years|
|Loan 1||4%, No points||$477.42||$171,869.51|
|Loan 2||3.875%, 1 point||$467.38||$168,257.40|
|Savings from paying points||$10.04||$3,612.11|
Recouping the Cost of Mortgage Points
If you pay 1 point, which will cost you $1,000 on a $100,000 mortgage (remember, each point costs 1% of your home loan amount) to get the 3.875% rate, you lower your monthly payments by about $10. (Our mortgage calculator will determine the monthly payment for any amount or interest rate.) That means it would take 100 monthly payments, or more than eight years, to recoup the upfront cost of that point. You won’t really start saving any money until then, and therein lies the problem.
Chances are, you won’t keep your loan much longer than that since the typical homeowner pays off a loan in just over eight years, according to data compiled by Bloomberg News. The problem is that most people sell their house or refinance before the full loan term ends, so there’s a good chance you’ll sell it before you ever recoup any savings.
Think about it: do you really plan to stay in your house for 30 years? And selling or refinancing before the break-even point means you’ll actually wind up paying extra interest on the loan.
Mortgage Points May Not Be A Smart Financial Move
If you’ve just bought your dream home and know you’ll keep your low-interest mortgage until your now-kindergartner graduates from high school, paying points may be the right move for you. You’d be the exception, though, because it’s pretty common to buy a starter home with a plan to upgrade in about five years. Others might relocate for work or personal reasons. Or, while it’s not particularly pleasant to think about, you may end up in a position where you’re forced to refinance or sell before breaking even on those purchased points because of an unexpected life challenge, like divorce, death of a spouse, disability or job loss.
That’s why Richard Bettencourt, a mortgage broker in Danvers, Massachusetts, and former president of the Association of Mortgage Professionals, says paying mortgage points typically isn’t a good financial move.
“The only way I see a point making sense is for that rarity of the person who says, ‘I’m going to make all 360 payments (on a 30-year home loan) and never move,’” he said.
What about having a home seller pay points to buy down your rate? Isn’t that a good deal for a buyer?
“Do you want the seller to reduce your monthly payment by $20 for the next 30 years or give you $7,500 to refinish the kitchen now?” Bettencourt said.
Another way to look at mortgage points is to consider how much cash you can afford to pay at the loan-closing table, says Mark Palim, vice president of applied economic and housing research for Fannie Mae, a government-owned company that buys mortgage debt.
“If you use up some of your savings toward prepaying your interest, which makes your payment lower on a monthly basis, you have less savings if the water heater breaks,” he said. “Does it make sense to put more of your savings into the transaction to lower the monthly mortgage payments?”