Mortgage Points: What They Are and When They Make Sense

While they require upfront cash, mortgage points can significantly reduce your monthly payments and total interest costs when used strategically.

This article will explain how mortgage points work and provide the tools you need to calculate whether it's the right decision for your financial situation

What Are Mortgage Points?

Mortgage points are a fee you pay to the lender in exchange for a lower interest rate. This can lead to significant savings on interest, depending on the mortgage terms. Real estate agents often refer to this practice as "buying down the rate."

Types of Mortgage Points

• Discount points: These buy down your interest rate and are the most common type. Discount points reduce the interest rate for the entire loan term, while origination points do not affect your rate.
• Origination points: These compensate the broker or lender for processing, approving, and funding the loan, but don't reduce your interest rate.

Key Differences Between Mortgage Point Types

Understanding the distinction between these point types is crucial for making informed decisions:

1. Purpose: Discount points buy down the interest rate, while origination points compensate the broker or lender for loan processing.
2. Rate impact: Discount points reduce the interest rate, while origination points don't.
3. Tax implications: Discount points can be tax-deductible as mortgage interest, but origination points generally aren't.

How Mortgage Points Affect Interest Rates

Discount points are fees the borrower pays upfront to the mortgage lender to reduce the mortgage rate. This is typically known as "buying down the rate." You might pay 1% of the loan amount to reduce the rate by 0.25%.

This reduces your monthly payments, which can significantly reduce the interest you pay over the life of the loan. The reduction you can expect varies depending on the type of loan:

Common Misconceptions About Mortgage Points

• Points are required: Borrowers may think points are required when taking on a mortgage, but they are optional.
• One point equals 1% rate reduction: It may seem like one point should equal a 1% drop in interest. However, the common reduction is 0.25% per point.
• All points are tax-deductible: Discount points are often tax-deductible, but origination points usually aren't.
• Points always save money: While points can lead to substantial savings in the long run, they may not save you money if you don't stay in your home long enough to break even.

How Much Do Mortgage Points Cost?

Standard Mortgage Points Pricing Structure

The cost of one mortgage point is usually 1% of the loan amount. Remember that one point typically reduces the interest rate by 0.25%, while two points would reduce the rate by 0.50%.

Mortgage Points Calculations by Loan Amount

Here are three examples illustrating mortgage points for different loan amounts:

$200,000 Loan:

• 1 Point = 1% of $200,000 = $2,000
• 0.5 Points = 0.5% = $1,000
• 1.5 Points = 1.5% = $3,000

$400,000 Loan:

• 1 Point = 1% of $400,000 = $4,000
• 0.75 Points = 0.75% = $3,000
• 2 Points = 2% = $8,000

$600,000 Loan:

• 1 Point = 1% of $600,000 = $6,000
• 0.25 Points = 0.25% = $1,500
• 1.25 Points = 1.25% = $7,500

Factors That Affect Mortgage Points Costs and Value

• Lender pricing: Each lender sets individual price points, and pricing models may vary between institutions.
• Market conditions: Current interest rate environments can influence mortgage points, such as when rates are rising or falling.
• Loan terms: The type of loan or its specific terms can influence the cost and value of mortgage points.
• Borrower finances: Your debt-to-income ratio or creditworthiness may affect pricing and available discounts.

Pros and Cons of Paying Mortgage Points

Advantages of Paying Mortgage Points

• Lower interest rates: Paying discount points on a mortgage results in lower interest rates for the entire loan term.
• Reduced monthly payments: A lower interest rate means less interest, resulting in lower monthly payments that improve cash flow.
• Long-term savings: Although you pay extra upfront, the overall cost can be significantly lower in the long term.
• Potential tax benefits: Mortgage points can be tax-deductible, potentially lowering your taxable income if you itemize deductions.
• Better loan affordability: Makes your loan more affordable over time, especially if you secure a low, fixed rate before rates rise.

Disadvantages and Risks of Mortgage Points

• Higher upfront costs: Each point generally costs 1% of the mortgage balance, meaning one or two points can cost several thousand dollars upfront.
• Long breakeven periods: Mortgage points can lead to significant long-term savings, but it sometimes takes years before you pay less overall.
• Opportunity costs: Money spent on mortgage points can't be used elsewhere, such as for paying down other debts or investments.
• Limited benefit for short-term loans: The interest savings may not be worthwhile for short-term loans, such as those with 10 or 15-year terms.
• Variable value: Some lenders don't provide significant discounts for points, so the savings may not always offset the cost.

Real-World Scenarios: When Mortgage Points Pay Off

Scenario 1: Long-term homeownership

A $300,000 mortgage with an interest rate of 7.0% and one discount point provides a rate of 6.75%. One point costs $3,000 and reduces the monthly payment by $50. Making payments for 30 years results in $15,000 in total savings.

Scenario 2: Larger loan, medium-term stay

A $600,000 loan with an interest rate of 6.875% and one discount point provides a rate of 6.625%. One point costs $6,000 and reduces monthly payments by $94. Making payments for 20 years results in $22,560 of savings.

Scenario 3: Jumbo loan buydown

A $900,000 loan with an interest rate of 6.75% and 1.5 discount points provides a rate of 6.375%. The 1.5 points cost $13,500 and provide $222 of monthly savings. Making payments for 15 years results in savings of $26,400.

When Mortgage Points Lead to Financial Loss

Early sale or refinancing

A $400,000 loan with one discount point for $4,000 provides $66 of monthly savings, but if the home is sold after 36 months, it only provides $2,376 in total savings, significantly less than the upfront cost.

Tight budget situations

A $250,000 mortgage with one discount point for $2,500 provides $45 in monthly savings. If the borrower's tight budget forces them to use credit cards to cover part of the point cost, the high-interest debt could negate any savings.

Tax Implications of Mortgage Points

• Discount point deductibility: Discount points may be tax-deductible, potentially reducing taxable income when you itemize deductions.
• Origination point treatment: These are considered lender fees and do not reduce taxable income.
• Itemization requirement: You can only claim a tax deduction for discount points if you itemize on your tax return rather than taking the standard deduction.
• IRS criteria: Points must meet specific IRS criteria to qualify for a deduction, including being clearly labeled on the closing disclosure and calculated as a percentage of the loan amount.

When Paying Mortgage Points Makes Sense

Ideal Borrower Profiles

• Large loan amounts: Discount points provide discounts as a percentage of the loan amount, so larger loans see greater absolute savings.
• Long-term homeowners: Paying for discount points lowers your monthly payment, so staying in the home longer results in more total savings.
• Fixed-rate mortgage borrowers: Discount points reduce the rate for the entire term, which can be particularly valuable on a fixed-rate mortgage compared to an adjustable-rate mortgage.
• No refinancing plans: Refinancing means taking on a new loan, so you'll lose discount point benefits unless you pay again. Points are better deals if you don't plan to refinance soon.

Market Conditions That Favor Mortgage Points

• High-interest-rate environments: A rate reduction provides more significant savings when rates are higher, making points more valuable.
• Stable or rising rate expectations: Locking in a rate reduction is better when rates are expected to stay the same or rise rather than fall.
• Favorable market conditions: Points may be less beneficial when rates are falling or expected to drop, as future refinancing might offer better terms.
• Competitive housing markets: When buyers already need to stretch their budget to win bids, paying extra for points may not be ideal since that money might be better used for higher down payments or covering appraisal gaps.

How the Length of Homeownership Affects Mortgage Points Value

"If buying points costs you $6,000 and only saves you $50 a month, it takes ten years to recover that cost," says Mark Sanchez, Founder at Gator Rated.

"That can be fine if you plan to stay put and never refinance. But if you are selling or refinancing within five years, it rarely makes sense," adds Sanchez.

Long-term scenario (15+ years):

• Loan amount: $300,000
• 1 point cost: $3,000
• Rate without points: 7.0% → $1,996/month
• Rate with 1 point (6.75%): $1,946/month
• Monthly savings: $50
• Breakeven point: 60 months (5 years)
• Total savings over 15 years: $9,000
• Net gain: $6,000

Medium-term scenario (5 years):

• Same loan parameters as above
• Total savings over 5 years: $3,000
• Break-even reached exactly with no additional gain or loss

Short-term scenario (3 years):

• Total savings over 3 years: $1,800
• Points paid: $3,000
• Net loss: $1,200

Alternative Uses for Mortgage Points Money

• Larger down payment: Making a larger down payment is sometimes better, especially if it eliminates the need for private mortgage insurance (PMI).
• Emergency fund building: Having an emergency fund reduces the need to use high-interest debt for unexpected expenses.
• High-interest debt paydown: If you have significant high-interest debt like credit cards or personal loans, paying those down could lead to more savings than mortgage points.
• Investment opportunities: Money used for points could potentially earn higher returns through strategic investments, depending on market conditions and risk tolerance.

How to Decide if Mortgage Points Are Worth It

1. Determine point costs: Calculate the cost of points as a percentage of the mortgage amount. For example, one point on a $300,000 mortgage costs 1%, or $3,000.
2. Calculate payments for both rates: Determine the monthly payment on the loan with and without points using a mortgage calculator.
3. Find monthly savings: Subtract the monthly payment with points from the monthly payment without points. The difference is your monthly savings.
4. Calculate break-even point: Divide the cost of the points by the monthly savings. This gives you the break-even point in months.
5. Interpret results: Divide the break-even point by 12 to find how many years it takes to break even.

Pro Tip: Use online calculators like US Bank's mortgage points calculator to run simulations of different point amounts and automatically calculate break-even times for your specific situation.

Example Mortgage Point Calculation

• Loan amount: $300,000
• Points paid: 1 point = $3,000
• Interest rate without points: 7.0% ($1,996/month)
• Interest rate with 1 point (6.75%): $1,946/month
• Monthly savings: $1,996 – $1,946 = $50
• Break-even point: $3,000 ÷ $50 = 60 months, or 5 years

Pro Tip: When shopping lenders, ask, "How much will each point reduce my interest rate?" since reductions vary by lender. Also, verify whether you're paying discount points (which lower your rate) or origination points (which are just service fees).

Conclusion

Mortgage points can be a powerful tool for reducing long-term borrowing costs, but they're not right for every situation. The key is understanding your financial goals, homeownership timeline, and opportunity costs before making this significant upfront investment.

Frequently Asked Questions

1. How much do mortgage points typically cost?

One mortgage point typically costs 1% of your loan amount. For a $300,000 loan, one point would cost $3,000, and usually reduces your interest rate by about 0.25%.

2. Can I pay partial points instead of full points?

Yes, many lenders allow you to pay fractional points, such as 0.5 or 0.75 points. This gives you the flexibility to customize your rate reduction and upfront costs.

3. Are mortgage points tax-deductible? Discount points are often tax-deductible if you itemize deductions, but origination points generally aren't. Consult a tax professional for your specific situation.

4. What happens to my points if I refinance early?

You lose the benefit of points when you refinance, as you're essentially getting a new loan. This is why points work best for borrowers who plan to keep their loan long-term.