If you're shopping for a new home, you're most likely watching mortgage rates, too. You've probably noticed many ads for banks and mortgage companies include small print regarding "points." What are points? More importantly, how do points affect your mortgage and should you pay them? Before you make a commitment to buy a home and secure a mortgage, you'll be well served to learn about mortgage points and examine your own finances to determine if you should buy points or pass.
One mortgage point is equivalent to 1% of the total loan amount; not the purchase price of the home you buy. There are two types of mortgage points: origination and discount points. We'll examine both types in this article.
An origination point is a non-deductible fee paid to the lender to compensate the loan company or bank for evaluating, processing, and approving your mortgage. Origination points are not set and may vary from lender to lender. So, you may be able to negotiate the number of origination points assessed on your mortgage. Remember, because one mortgage point is equivalent to 1% of the total loan amount, for a $200,000 loan, one origination point will cost $2,000. Two points will cost $4,000, and so on.
A discount point is a portion of interest on your mortgage actually paid at closing. In return for pre-paying this portion of interest, you'll pay a lower interest rate on your mortgage and will, thus, lower the amount of your mortgage payments. Generally, each discount point purchased at closing will reduce the interest rate on your mortgage by .25%. However, this discount varies depending on the lender and fluctuations in the bond market.
Provided that you itemize your tax return, discount points are tax deductible: You can find the exact requirements for this deduction in IRS Publication 936, Home Mortgage Interest Deduction.
Let's look at an example of how discount points might benefit a homebuyer. If a lender allows a homebuyer to purchase four discount points on a $200,000 mortgage, each point will generally be worth $2,000. So, four points on a $200,000 mortgage will cost approximately $8,000; paying these points will generally reduce a homebuyer's mortgage interest rate by 1%.
Are Discount Points Worth Paying?
Should you pay discount points? That depends on several factors. First, you should ask yourself questions such as: How long will I keep this home? Do I have extra cash on hand to pay the points? Should I use the money for a something I need more, or that will bring a greater long-term benefit, such as buying new appliances for the home or funding an IRA? There is no one right answer—it varies by individual circumstances and priorities.
To get a better picture of the implications of paying points, let's look at a hypothetical example. For a 30 year, fixed-rate, $200,000 mortgage, let's look at the breakeven point—how long you need to stay in a home to realize a savings from having paid for points -the chart below will help us:
|Cost of Points||$ 0.00||$ 2,000||$ 4,000||$ 6,000||$ 8,000|
|Monthly Points and Interest Cost||$ 1,193||$ 1,162||$ 1,130||$ 1,100||$ 1,069|
|Year 1||$ 14,316||$ 15,944||$ 17,560||$ 19,200||$ 20,828|
|Year 2||$ 28,632||$ 29,888||$ 31,120||$ 32,400||$ 33,656|
|Year 3||$ 42,948||$ 43,832||$ 44,680||$ 45,600||$ 46,484|
|Year 4||$ 57,264||$ 57,776||$ 58,240||$ 58,800||$ 59,312|
|Year 5||$ 71,580||$ 71,720||$ 71,800||$ 72,000||$ 72,140|
|Year 6 -
|$ 85,896||$ 85,664||$ 85,360||$ 85,200||$ 84,968|
|Year 10||$ 143,160||$ 141,440||$ 139,600||$ 138,000||$ 136,280|
|Year 20||$ 286,320||$ 280,880||$ 275,200||$ 270,000||$ 264,560|
|Year 30||$ 429,480||$ 420,320||$ 410,800||$ 402,000||$ 392,840|
Note: Lost earnings on funds used to pay points, and savings realized in income tax are not considered in the above chart.
As seen in the chart, from years 1-5, the borrower in our example would be better off financially to not pay discount points and accept a higher interest rate. However, after the 5th year, the borrower would come out ahead financially, and actually have saved money, if he or she had bought as many discount points as was affordable. So, we see the longer you expect to stay in a newly purchased home, the stronger the argument is for purchasing discount points.When you've found the perfect home, and you're shopping for the best mortgage, ask the lender you're considering to put together a chart similar to the one above, or put together your own so you can see how many years you'll need to plan to stay in your home to benefit from purchasing discount points at closing. Generally, as long as you can spare the cash and plan to stay in your home past the breakeven point, discount points are a good way to lower your mortgage payments.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.