When you’re applying for a mortgage, you may encounter the term mortgage points, also known as discount points or loan points. These are upfront payments you can make to your lender in exchange for a reduced interest rate on your mortgage loan. While mortgage points can be a useful tool for lowering your monthly payments and overall interest costs, they are not always the best choice for every borrower.
In this post, we’ll break down how mortgage points work, the types of points available, and when it makes sense to use them as part of your home financing strategy.
What Are Mortgage Points?
Mortgage points are fees paid directly to the lender at the time of closing in exchange for a lower interest rate. One mortgage point is typically equivalent to 1% of your loan amount. So, if you’re taking out a $300,000 mortgage, one point would cost you $3,000.
There are two types of mortgage points you should be aware of:
- Discount Points
Discount points are the most common type of mortgage point and are used to lower your interest rate. By paying discount points upfront, you can reduce your monthly mortgage payments, potentially saving you thousands of dollars over the life of the loan. - Origination Points
Origination points are fees that the lender charges for processing the loan. These points are not used to lower the interest rate but instead cover the lender’s costs associated with underwriting the mortgage. Origination points typically cost the same amount as discount points (1% of the loan amount), but they don’t affect the interest rate or your monthly payment.
For the purposes of this article, we’ll focus primarily on discount points, as they directly impact your mortgage rate and long-term costs.
How Do Mortgage Points Work?
When you opt to buy mortgage points, you essentially pay the lender upfront in exchange for a lower interest rate on the loan. The more points you purchase, the more your rate can be reduced, though the exact reduction varies depending on the lender and market conditions. Typically, one point will lower your interest rate by about 0.25%, although this can vary.
For example, if your mortgage interest rate is initially 4.5% and you decide to buy one point, you might be able to reduce your rate to 4.25%. While you’ll pay an additional $3,000 upfront (in the case of the $300,000 loan), your monthly payments will be lower because you’re paying a reduced interest rate.
Example of Mortgage Points in Action:
Let’s say you are taking out a $300,000 mortgage. Without any points, your interest rate is 4.5%, and your monthly principal and interest payment is about $1,520. Over the life of a 30-year loan, you would pay approximately $247,000 in interest.
If you decide to pay for one discount point (costing $3,000), your interest rate might drop to 4.25%, lowering your monthly payment to about $1,475. While you’ll pay $3,000 at closing, you’ll save around $45 per month. Over the 30-year term, that’s $16,200 in savings on interest.
However, keep in mind that the break-even point—when the savings from the lower interest rate outweigh the upfront cost—may take several years to reach, depending on how many points you buy and how long you stay in the home. More on this in the next section.
When to Use Mortgage Points
Mortgage points can be a smart choice in certain situations, but they may not always make financial sense. Here are a few scenarios where buying points might be beneficial:
1. Long-Term Homeowners
If you plan to stay in the home for a long period—say, 10 years or more—buying mortgage points can be a good strategy to lower your long-term costs. Over time, the upfront cost of the points will be outweighed by the savings in interest. The longer you hold the mortgage, the more you’ll save.
For example, if you buy 2 points for a $300,000 loan at 4.5%, reducing the rate to 3.75%, you would pay $6,000 upfront but save $90 per month. After about 67 months (roughly 5.5 years), you’ll have recouped the cost of the points, and any additional savings after that will be pure profit.
2. Lower Monthly Payments
If reducing your monthly payments is a priority, paying for mortgage points can help you achieve that goal. By lowering the interest rate, you’ll make lower monthly payments, which may be important if you’re budgeting for other expenses, such as home improvements or education costs.
3. When Interest Rates Are Low
Buying mortgage points is most beneficial when interest rates are already low. If you can lock in a favorable rate and purchase points to reduce it further, you can enjoy significant long-term savings without paying too much upfront. If interest rates are high, however, the cost of buying points may not make as much sense, as the upfront cost may not provide enough of a reduction in the overall interest paid.
4. Tax Deductibility
In some cases, the cost of mortgage points can be tax-deductible, particularly if you’re purchasing a primary residence. The IRS allows homebuyers to deduct the cost of mortgage points as part of their itemized deductions. However, it’s important to consult with a tax professional to determine if you’re eligible and to understand the specific tax implications of buying points.
When Not to Use Mortgage Points
While mortgage points can offer significant savings in certain situations, they aren’t always the right choice for everyone. Here are some scenarios when you might want to skip the points:
1. Short-Term Homeowners
If you don’t plan to stay in the home for a long time, buying points might not be worth the upfront cost. Since the savings from a lower interest rate take time to accumulate, homeowners who sell or refinance within a few years may not recoup the cost of the points.
2. Tight Budgets
Paying for mortgage points requires additional upfront money. If you’re already stretched thin with a down payment, closing costs, and other expenses, buying points might not be financially feasible. In this case, it may be better to put your money toward other costs, like reducing your down payment or having more cash reserves.
3. Alternative Investment Opportunities
Another consideration is opportunity cost. If you can invest the money you would spend on mortgage points in other ways—such as paying off high-interest debt or investing in the stock market—you might see a better return than the savings on your mortgage. If you’re unsure, it’s a good idea to talk to a financial advisor to help weigh your options.
Conclusion
Mortgage points can be a powerful tool for homeowners who plan to stay in their homes long-term and want to reduce their monthly payments and overall interest costs. However, the decision to buy points should be made carefully, considering your financial situation, how long you plan to stay in the home, and the cost of the points versus the savings you’ll receive. By understanding how mortgage points work and when they make the most sense, you can make a more informed decision and potentially save thousands of dollars over the life of your loan.
