For many people, buying a house is the most expensive purchase they’ll make during their lives. Since that’s the case, it isn’t uncommon to look for ways to reduce the monthly payments and overall cost. While negotiating is undoubtedly a great option, paying for points is another viable approach. If you’re wondering what mortgage points are, how they work, and whether they’re a good way to reduce your mortgage rate, here’s what you need to know.
What Are Mortgage Points?
Technically, mortgage points are a fee borrowers can pay as they set up a mortgage for a purchase or refinance. Homeowners can choose to pay the cost in exchange for securing a lower interest rate, though the fee is actually optional. There’s no requirement to buy points, so homeowners can choose to forgo the expense and keep the original interest rate offered.
How Mortgage Points Work
In some ways, mortgage points are a way to prepay interest. In exchange for a fee, the lender agrees to give you a better rate. Essentially, you’re compensating the lender for lost income, as the lower rate means they’ll earn less off of your loan over its life.
Mortgage points reduce an interest rate associated with a home loan by a set amount. In most cases, one point shrinks the interest rate by about 0.25 percent. For example, one point would turn a 5 percent interest rate into a 4.75 percent rate.
It’s important to note that each lender can set the value of their points. As a result, some may offer 0.25 percent per point, while others may reduce the rate by 0.125 percent, 0.2 percent, 0.3 percent, 0.35 percent, or any other amount they choose. However, the reduction must be disclosed to borrowers in advance, ensuring they know precisely what they’re getting in return for the fee.
If a borrower decides to buy points, they pay the cost at closing. The points are listed in the mortgage documentation, ensuring the new rate is officially part of the loan structure. Once the homebuyer closes, the rate after the deductions for any points purchased remains in place for the life of the loan.
The Cost of Mortgage Points
As with mortgage point values, each lender can determine its own cost for purchasing points. However, most lenders charge a fee of 1 percent of the loan total per point. For example, if you were financing $300,000, you’d pay $3,000 per point. If you wanted two points, that would cost $6,000.
While it may seem like 1 percent is the minimum amount you can pay, that isn’t always the case. Some lenders do allow borrowers to purchase fractional mortgage points. Using the example above, a homebuyer may be able to spend $1,500 to get a half-point on a $300,000 loan.
If they do, they secure an interest rate reduction that’s half the full point amount. For instance, if a whole point reduces the interest rate by 0.25 percent, a half-point would be worth 0.125 percent. For an initial interest rate of 5 percent, that half-point leads to a 4.875 percent interest rate instead.
Pros and Cons of Mortgage Points
Mortgage points do come with pros and cons. When it comes to the benefits, the biggest is that paying points can save you money over the life of your loan, particularly if you plan on staying in place long-term. If you want to confirm the savings, you’ll need to compare the total interest paid based on the two possible interest rates. That way, you can see the overall savings and compare that to the cost of the points.
If you don’t intend to stay in the home forever or may refinance in the future, you’ll want to find out if you’ll save enough to offset the price of any points. Usually, that involves calculating the breakeven point, which is the month that your interest savings covers the amount you spent on points. Precisely when that occurs varies depending on your loan terms, though you can use an online calculator to make determining when that happens easier.
Paying points may also help you qualify for a home loan if the monthly mortgage payment is higher than a lender finds comfortable. When you reduce the interest rate, the monthly payment goes down, potentially to the point where you become eligible for your preferred loan.
In some cases, the cost of your mortgage points is also tax-deductible. Since it’s considered prepaid interest, it can lead to deductions similar to traditional home loan interest payments. Precisely what that’s worth depends on your tax situation, so you’ll want to speak with a tax professional to see if this provides suitable value.
When it comes to drawbacks, the biggest is the higher upfront cost. While you might be able to convince the seller to cover the cost in exchange for a higher offer, paying out-of-pocket is far more common. That means paying potentially thousands of dollars in addition to your down payment, which may not be easy.
It’s also that paying points will cause you to pay more for your mortgage than you would without them. If you unexpectedly need to move or decide to do a cash-out refinance to consolidate debt or tackle some upgrades before the breakeven point, paying points costs you extra money instead of saving it.
If you’re looking at an adjustable-rate mortgage (ARM), reaching the breakeven may be impossible. Usually, the points only count during an initial fixed-rate period. If the breakeven point doesn’t occur during that window, then the points could also cost you more.
Is the Cost of Mortgage Points Negotiable?
Generally speaking, the cost for mortgage points isn’t negotiable. However, if you have exceptional credit and a solid down payment, you may be able to negotiate to lower the cost of certain other expenses, like origination fees or certain closing costs. By doing so, mortgage points may feel more affordable, even if the price of each point remains the same.
Is Paying Points a Good Idea?
Whether paying points is a good way to reduce the cost of buying a home depends on your unique situation. If you know with a reasonable amount of certainty that you’ll remain in the house and with your current lender until at least the breakeven point, it’s worth considering. Anything after the breakeven point is pure savings, giving you a clear financial benefit.
Similarly, if you can afford your dream home, but the lender is hesitant to fund a mortgage with a particular monthly payment because of your income level, paying points could be worthwhile. It could let you reduce the monthly amount to the point that leaves your preferred lender comfortable, allowing you to qualify when you otherwise wouldn’t.
Otherwise, it may be best to skip mortgage points. Those who plan to leave before the breakeven point won’t secure a savings. In fact, anyone who makes extra payments may struggle to recoup the cost if they ever move.
Similarly, refinancing before the breakeven point results in a loss, making points an awful idea. Finally, if paying points means not having enough for a down payment to avoid PMI, get the most favorable initial interest rate, or secure a lower homeowner’s insurance rate, then it may be better to go without paying for points.
Look at your overall financial picture and the plan for your home. That way, you can determine whether points are genuinely right for you.
Do you think that paying points to reduce your mortgage rate is a smart approach when you’re getting a mortgage? Do you believe that other techniques are more effective when it comes to securing a great rate or keeping costs down? Share your thoughts in the comments below.
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Tamila McDonald has worked as a Financial Advisor for the military for past 13 years. She has taught Personal Financial classes on every subject from credit, to life insurance, as well as all other aspects of financial management. Mrs. McDonald is a former AFCPE Accredited Financial Counselor and has helped her clients to meet their short-term and long-term financial goals.