Buying a house requires months of endless decision-making. Where do you want to live for the next several years? Whom will you hire as an agent? Which bank will get your business?
But once you finally reach the finish line and are presented the mortgage contract, you’ll have one more decision to make: Should you buy down the rate?
Also known as paying points, this choice can be a confusing one. But no worries ― we have the lowdown on how mortgage points work and when it makes sense to pay them.
What are mortgage points?
When it comes to mortgage points, there are a few different kinds. Usually, though, we’re talking about discount points, which are used to lower your mortgage interest rate.
Lenders offer this option because they know mortgage borrowers don’t always stay in their homes for the full duration of the loan.
For example, say a young couple wants to take out a 30-year fixed-rate mortgage. Well, the lender knows that the couple is pretty unlikely to stay in that house for 30-plus years while they pay down the loan. Instead, they’ll probably stay for maybe three to five years, and then when they decide to start a family or relocate for work, they’ll sell the house and move on.
In this case, the lender gets paid a lot less interest over the life of the loan than if the loan had fully amortized. So, to hedge its bets, the bank offers that couple the opportunity to pay a fee upfront in exchange for a lower-than-market interest rate.
“Essentially, mortgage points are prepayment of interest,” said Yves-Marc Courtines, a certified financial planner and former mortgage banker who now runs Boundless Advice LLC in Manhattan Beach, California. Paying interest in the form of an upfront fee can accomplish two things, he said: Provide a more palatable interest rate to the borrower, as well as help the mortgage lender absorb some of its costs right away.
So even though the couple has to pay more money upfront, it can be psychologically rewarding to get a deal on the interest rate. Meanwhile, the lender gets to have more cash on hand right away, rather than waiting for those monthly payments to trickle in and hoping the couple holds onto the loan long enough for it to be a lucrative deal.
But don’t assume that mortgage points are a big scam ― they can actually work out in the favor of the borrower. It all comes down to the math.
How much are mortgage points worth?
Discount points cost 1 percent of your total loan amount. So, for example, 1 point on a $100,000 loan would cost $1,000.
But when it comes to how much each one is worth, it all depends on the lender. Generally, though, 1 point will reduce your rate by an eighth to a quarter of a percent.
Calculating your break-even point
Whether paying points turns out to be a good deal for the lender or for you depends on how long you end up staying in the home. Let’s look at an example:
You walk into a bank and apply for a 30-year fixed-rate loan of $100,000. The bank says you qualify for a rate of 4.5 percent. However, it offers you the option to buy 4 discount points and, in exchange, you’ll receive a rate of 3.5 percent instead.
If you take the deal, you will owe an extra $4,000. However, at that lower interest rate, your monthly payments would be $467 instead of $507, assuming you roll the cost of the points into your loan balance.
That means you would save $40 a month and break even after 10 years. Every year you remain in your home after that is another $480 in your pocket instead of the bank’s. “That’s an awesome return on investment,” said Courtines.
But if you end up moving in just a few years, he said, you’ve made a bad decision.
Pros and cons of paying for points
One of the biggest advantages of mortgage points: “They help to make the monthly payment more affordable,” said Courtines. A lower monthly payment means you’ll not only have more cash flow to put toward bills or investments, but you might also have a better chance of qualifying for a loan in the first place.
“The bank might say, ‘You don’t make enough money from your salary to pay $3,000 a month, but you do make enough money to pay $2,800 a month,’” Courtines explained. “So you can make the loan smaller by paying points.”
Of course, there are also the long-term savings. If you plan to stay in your home past the break-even point, you stand to save thousands of dollars in interest.
And there are tax benefits. Because mortgage discount points are considered prepaid interest, you can deduct the cost on your taxes as long as you meet the IRS requirements.
On the other hand, one of the drawbacks to paying points is you’ll need to have more cash at closing. If not, you have to roll that cost into the loan balance, which increases the ultimate price of the points because you end up paying interest on them.
The other big risk? “You may not be in the loan long enough to earn back the value of the reduced interest rates,” said Courtines.
Finally, you could get ripped off. “You may think you’re getting a great interest rate,” said Courtines, “but may have overcompensated the lender or mortgage broker by paying more points upfront than the amount they’re giving you back in lower rates.”
That’s why it’s so important to calculate the upfront cost versus long-term savings. The rate can’t just look good on paper ― it has to be mathematically better than the no-point rate, according to Courtines.
What about negative points?
The opposite of a discount point is a negative point. This is when the lender essentially pays you, usually by reducing your closing costs, in exchange for a higher interest rate. For instance, taking our same $100,000 loan as an example, a lender might credit you 1 negative point ― $1,000 ― and increase your interest rate by 0.25 percentage points.
Why would you want to do this? There are a couple reasons it might make sense.
One is if you’re taking out a large loan that requires a major upfront closing fee ― more money than you have on hand. This situation is typical in high-cost housing markets such as San Francisco and New York City. Sometimes, taking the negative point can get you into a home you could not otherwise afford.
The other situation when you would want to take a negative point is when you don’t plan to stay in the home for very long. If you’re only planning to hold the mortgage for a couple of years, saving immediately on closing costs could make up for the slightly higher rate.
Bottom line: Are mortgage points worth it?
In the end, lenders charge mortgage points because they hope to come out ahead on the deal. But that doesn’t mean it can’t be a win for you too.
Paying for mortgage points can get you into a home you would not otherwise be able to afford and save you money over time. Just be sure to crunch the numbers before signing on the dotted line.