Mortgage lenders earn thousands of dollars every time they close a loan. Although they earn that money in many different ways, one is by charging borrowers upfront fees called points.
Don’t want to pay points among your closing costs? And when is it worth paying for points in exchange for a lower interest rate? Read on to find out how mortgage points work.
What Are Mortgage Discount Points?
A mortgage point is a fee charged at the settlement table. One point equals 1% of the loan amount.
For instance, if you take out a $200,000 mortgage, one point would equal $2,000. As you see, they can add up quickly.
Points come in two varieties: origination points and discount points. Lenders charge origination points simply to pad their bottom line and make more money off your loan. Often lenders use origination points to pay the loan officer who worked on your loan — remember, loan officers are salespeople, and they earn money on commission.
In contrast, discount points are optional. You can voluntarily pay discount points to “buy down” your interest rate.
How Mortgage Discount Points Work
When you elect to pay discount points, you offer to pay an upfront fee in exchange for a lower interest rate.
For example, imagine you’re considering a $200,000 home loan at 3.5% interest. Your mortgage lender makes you the following offer: by paying one discount point at settlement, you can lower your interest rate to 3.25%.
Such an offer may or may not make sense for you — more on that shortly.
You can often pay several points to buy down the interest rate even lower, or pay half a point for a smaller discount, and so forth.
Lenders allow you to do this for a few reasons. First, they know many homeowners either sell or refinance within a few years, so it makes sense for them to charge you interest upfront. They know you may not keep your loan long enough for your savings on interest to catch up with the upfront fee you paid.
Additionally, lenders are happy to take a guaranteed upfront payment rather than waiting around for you to pay them more interest. You could default on the mortgage loan, and they might never see that interest. For that matter, collecting more money now means collecting money in today’s dollars, without risk of inflation eating away at the value of each dollar of interest they collect in the years to come.
Bear in mind too that the lender you work with probably won’t keep your loan for the long run. Most retail mortgage lenders sell loans on the secondary market immediately after they close. The end buyer, however, is willing to accept a lower interest rate in exchange for a point upfront.
Should You Buy Mortgage Discount Points?
Returning to the example above, you have the option to buy down your interest rate from 3.5% to 3.25% by paying one discount point. Should you do it?
It turns out there is a “right” answer to that question, sort of. You can calculate how many years it would take you to break even on that deal — how many years until the savings on interest caught up with the upfront fee you paid.
In this case, a 30-year, $200,000 mortgage at 3.5% interest would cost you $898 per month in principal and interest. At a 3.25% rate of interest, it would cost you $870, a monthly savings of $28. So, it would take you 71 months (around six years) to recoup your initial $2,000 cost to buy one point. After six years you’d reach the break-even point, having saved more than $2,000 in interest.
Benefits of Mortgage Points
Discount points come with exactly one benefit: a lower mortgage interest rate.
By reducing your monthly payment, you reduce your debt obligations and therefore your living expenses. Many people don’t mind paying an upfront fee to lower their long-term expenses. Think of it like an investment, which pays off eventually once your savings catch up with your sunk cost.
If you itemize your tax deductions, you may be able to deduct point costs on this year’s tax return. The IRS allows you to deduct mortgage interest, and as prepaid interest, points are tax deductible.
When You Should Buy Mortgage Points
Only consider buying points if you know you’ll keep your loan longer than the breakeven period.
Of course, life is unpredictable, so it’s hard to make plans for years down the road. You could score your dream job two years from now, but it might require you to move out of state. You might get divorced in three years, and your spouse could get the house in the divorce settlement. Or in four years, you might need more money than your emergency fund can cover, and do a cash-out refinance to pull out home equity.
And what about the opportunity cost of investing that money instead of buying down your interest rate? In the example above, it would take around six years to break even and start coming out ahead. But that ignores what you could have earned had you invested that $2,000 in the stock market. At an average historical return of 10%, that $2,000 would have transformed into $3,543 after six years, making it the better investment.
The upfront cost of discount points particularly make no sense for adjustable-rate mortgages (ARMs). These loans are designed for refinancing into fixed-rate mortgages, once the low-interest period ends.
I can conceive of scenarios where it might make sense to buy down your interest rate. If you’re retired or nearing retirement and you plan to age in place, buying down your interest rate makes a safe investment at a time when you have little appetite for risk. But for the average homebuyer, it makes more sense to invest the money in the stock market instead.
Almost everything in life is negotiable, and that includes mortgage points.
You can negotiate down origination fees, particularly by shopping around and forcing lenders to compete for your business. Loan officers will quote you the highest fees and points that they think you’ll pay — they get paid on commission, after all.
You can also sometimes negotiate discount points. If your lender offers to reduce your interest rate by 0.25% for each point, try pushing for 0.35% instead. The more they discount your interest rate for each point, the faster your breakeven horizon.
Alternatively, put the money toward a higher down payment to avoid private mortgage insurance (PMI). Or just take the money you would have spent on discount points and put it toward buying index funds in your Roth IRA. Chances are you’ll have far more money to show for it by the time you retire.