What Are Mortgage Points?
Mortgage points (also called interest rate points or discount points) are fees you can pay to a lender at closing to lower your mortgage's interest rate -- or annual percentage rate (APR). The cost of each point is equal to one percent of the loan amount. For example, one mortgage point on a $300,000 mortgage would cost $3,000.
Buying Points on a Mortgage: Explained
If you're taking out a home loan, you can buy mortgage points from your mortgage lender to lower the APR on your loan. Not only could this save you tens of thousands of dollars in interest charges over the life of the loan, it could also reduce the size of your mortgage payment because you'd pay less in interest each month.
Here's how it works. Each mortgage point costs one percent of the loan amount (e.g. $3,000 will buy one point on a $300,000 mortgage loan). And each point you pay the lender when you are taking out your mortgage can decrease your interest rate from one-eighth to one-fourth of a percentage point, depending on the mortgage lender.
Let's say you want to take out a fixed 30-year $300,000 mortgage with a 6% APR to buy a house, which would amount to a $1,799 monthly mortgage payment (not including property tax, insurance or closing costs). If you had some extra cash beyond your down payment and wanted to reduce your mortgage payment, you could buy two points for $6,000 (1% of the mortgage amount X 2 points) to reduce the mortgage rate down to as low as 5.5% APR on closing day. That would lower your mortgage payment to just $1,703 per month.
Does it Make Sense to Pay Points on a Mortgage?
Paying for mortgage points to lower the APR on your home loan can mean paying thousands of dollars less in overall interest charges, but buying points may not make sense for cash-strapped borrowers who don't plan to keep the mortgage for more than 10 years. Buying mortgage points may also give you a tax benefit, allowing you to deduct the amount you paid for them from your taxable income.
Generally speaking, buying mortgage points may be worth it if:
1. You can put 20% down on a home to avoid having to pay private mortgage insurance,
2. You have several thousand dollars in extra cash after that, and
3. You plan to keep the mortgage for a decade or longer.
Put simply, the longer you intend to keep the home loan, the more buying mortgage points makes financial sense.
Mortgage Points Break Even Calculation
The formula to figure out how long it would take to break even (i.e. where the interest savings would be equal to the amount you paid for the mortgage points) would be:
Break Even = Cost of Points / Monthly Savings
So using our earlier example, if you were to take out a 30-year fixed, $300,000 mortgage at 6% interest, your mortgage payment would be $1,799 (not including taxes or insurance). If you were to buy two mortgage points for $6,000, that would lower your monthly payment to $1,703, saving you $96 per month.
Plugging it into our break-even mortgage points formula, we find:
Break Even = $6,000 / $96 = 62.5 months
In this example, you would need to hold onto the mortgage for 62.5 months, or a little more than five years, for you to recover the cost of paying for your two mortgage points. After 62.5 months, the amount of money you would save in interest charges would be greater than the amount you paid for the mortgage points.
Put another way, if you were to change mortgages or move into another home before 62.5 months in this example, you would not save enough in interest charges to recover the amount you spent buying the mortgage points.
Is it Better to Buy Mortgage Points or Make a Larger Down Payment?
In general, it may make most sense to use your cash to put 20% down on the home before paying for mortgage points.
If you can't put down enough cash toward a home to equal 20% of its value (e.g. pay $60,000 cash for a $300,000 home), most mortgage lenders will have you pay private mortgage insurance (PMI), which could cost between $50 to $100 per month for every $100,000 you borrow. If this is more than what you'd save in monthly payments from buying points, then it may be more worth it to put your cash toward a 20% down payment because you'd avoid PMI.
Let's return to our example again. Even if you were able to save $96 per month on your mortgage payment by buying two points on a $300,000 mortgage, you may have to pay up to $300 per month for PMI if you didn't put at least 20% down on the home.
In this case, you could be better off making a bigger down payment than buying mortgage points because the monthly PMI would be significantly higher than the monthly savings from a lower interest rate.
Further, you're not required to pay PMI any more when the equity in your home equals 20% or more of the home's value, so the closer you can get to 20%, the better.
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