What’s the point of buying mortgage points?
When mortgage rates rise, borrowers scramble to find ways to get the lowest possible interest rate. One option is to pay mortgage points to “buy down” your rate.
Buying down the rate means paying extra upfront fees to your mortgage lender, called “discount points,” to get a lower interest rate and monthly payment.
When interest rates are very low, few borrowers pay higher closing costs to get a discount. But as mortgage rates rise, borrowers are more likely to weigh the pros and cons of buying points to lower their mortgage rate.
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How buying mortgage points works
A mortgage point or discount point is equal to 1% of your loan amount. That’s $4,000 for a $400,000 mortgage. Essentially, you are paying to lower your interest rate. Using the $400,000 mortgage example:
- $400,000 mortgage at 3.25%
- One discount point costs $4,000 and lowers the rate 0.25%
- That point buys down the rate from 3.25% to 3%
- Over 30 years at 3.25%, you’d pay $226,607 in interest repayment
- Over 30 years at 3%, you’d pay only $207,109
- Total savings: $19,498
The rate reduction you get per point depends on your loan term and market conditions. Typically, for a 30-year fixed-rate loan, a discount point gets you a 0.125% to 0.25% lower mortgage rate.
However, the relationship between cost of the points and interest rate reduction is not perfectly symmetrical. Even for the same loan.
How to shop for loans with mortgage discount points
Here’s an example. Say one national lender offers a 30-year fixed-rate mortgage at 4.5% with no points. You can knock 0.25% off that and get 4.25% by paying half a discount point.
But a 4.125% rate (just 0.125% lower) costs an additional point. Paying more doesn’t necessarily get you a better deal.
When shopping for a mortgage with discount points, the easiest way to compare offers is to decide how much you want to spend, then see who offers the lowest rate at that price.
Alternatively, you can decide what mortgage interest rate you want, and see which lender charges the least for it.
Advantages of buying mortgage points
The biggest advantage of purchasing points is that you get a lower rate on your mortgage loan, regardless of your credit score. Lower rates can save you money on both your monthly mortgage payments and total interest payments for the life of the loan.
- If your income is too low for you to qualify for the house you want, you may be able to qualify with a reduced interest rate and payment
- If you have the cash available, or if you can convince a home seller to pay discount points for you, buying down your rate may help you qualify for your mortgage loan
- Purchasing points can save you money over the life of the loan, but typically when you don’t sell or obtain a mortgage refinance for enough year to break even
- Understand, though, that the upfront cost of mortgage points can be substantial
How much money can you save buying mortgage points?
Is purchasing points beneficial if you keep your new home for five years? You can figure it out by using a mortgage calculator.
Suppose it costs two points ($8,000) to reduce the interest rate on a $400,000 30-year fixed-rate loan from 4.5% to 4.0%. Your monthly mortgage payment for principal and interest would drop by $117 with the lower rate ($1,910 instead of $2,027).
After five years, with the 4.0% home loan, you’ll have paid $76,370 in interest payments, plus $8,000 in mortgage points, for a total of $84,370. You’ll have reduced your principal balance by $38,210.
With the 4.5% loan, you’ll have paid $86,236 in interest. You’ll have reduced your principal balance by just $35,368.
In this case, then, it will cost you $1,888 less over five years if you pay the discount points. But that’s not all. You’ll have reduced your balance by an extra $2,842. So your total savings in five years is $4,730.
One more advantage of paying mortgage points is that, since they represent prepaid interest, they are typically tax-deductible
Disadvantages of purchasing points
While lower monthly payments and potential savings over the life of the loan are clear benefits of buying mortgage points, there are some reasons you may be better off not purchasing points.
First, paying one or more points ties up your cash. If you’re making a down payment of less than 20% or have less than 20% in home equity when refinancing, you’ll probably have to pay for private mortgage insurance (PMI) if you have a conventional loan.
Have a lender or mortgage broker compare the impact of making a larger down payment to reduce or avoid PMI.
In addition, the sample calculation does not consider that you may have better uses for that money — for example, paying off high-interest credit card debt, making investments, or saving for future home improvements.
You may also want to use that money to invest in assets other than real estate for diversification, to boost a college tuition fund, or to pad your retirement account.
The money you pay towards lowering your mortgage interest rate may not bring the same rewards as other investment vehicles, but for homeowners who plan to stay put for the long-term, a lower interest rate could be a smart move.
Mortgage discount points FAQ
Paying for mortgage discount points on an adjustable-rate mortgage (ARM) only provides a discount during the ARM’s initial fixed-rate period. With a 0.25% discount rate, it generally takes around 4-6 years of homeownership to break even with these loan terms. Therefore, your opening fixed-rate period should be longer than 4-6 years to see a real savings.
Discount points and origination points are different. Origination points refer to the origination fees a borrower pays to their mortgage lender for processing and underwriting a home loan. Whereas, discount points are upfront fees home buyers pay at closing to reduce their mortgage interest rate.
One point costs 1% of your loan amount, or $1,000 for every $100,000. As an example, if your mortgage loan is $400,000, then one discount point would be $4,000. Additionally, many mortgage lenders will allow home buyers to purchase fractional points. On a $4000,000 home loan, a half point would cost $2,000.
What are today’s interest rates?
Current mortgage rates depend, in part, on what home buyers are willing to pay for a home loan. In general, higher interest rates go to those who pay less.
And remember, the lowest rate isn’t always the best deal. A good loan officer should be able to help you sort through your home-purchase options and choose the lowest-cost program for your needs.