When hunting for a new house to call home, getting the best mortgage for you is an important step. And you’ve likely started researching lending institutions and assessing what each has to offer already.
Selecting the most suitable mortgage loan involves weighing several factors, including mortgage rates, fees, down payment requirements, eligibility guidelines and closing costs, just to name a few. As you explore mortgage options, it’s vital to familiarize yourself with how the different loan products work.
It’s equally important to explore mortgage points and how they work to determine if they’re a worthwhile investment. But what are mortgage points, and how do they work? What do they cost? Read on to discover the answers to these questions and more. Plus, you’ll learn how to calculate the costs, weigh the benefits and drawbacks and what factors to consider when deciding if purchasing mortgage points makes financial sense for your unique situation.
Mortgage Points: What Do They Mean?
In a nutshell, mortgage points are a fee you can pay the mortgage lender upfront to cover processing costs or lower your interest rate on a home purchase or refinance.
By purchasing a point, you prepay the interest for a certain portion of your loan term, resulting in a lower annual percentage rate (APR) and lower monthly mortgage payments.
There are two types to be aware of – mortgage origination points and mortgage discount points.
Origination Points
The lender is compensated for originating, underwriting and funding the loan through what’s referred to as origination points. As a result, you can expect to pay between 1 and 1.5 percent of the total loan amount to have the loan processed. However, buying origination points will not affect the interest rate you receive.
It’s not uncommon for some lenders to offer home loans with little or no origination point assessments or closing costs. However, keep in mind that you’ll likely pay a higher interest rate or more in fees. You should also know that origination points are sometimes negotiable.
Discount Points
Discount points are a form of prepaid interest that directly lowers the interest rate on the home loan. Each point you purchase can reduce the interest rate by roughly 0.25 percent, which could make a sizable difference in your monthly payment and the amount of interest paid over the life of the loan.
What is the Breakeven Point?
The breakeven point is the timeframe (in months) that it takes to recoup the amount you spend on discount points. It’s calculated with this formula:
- Total cost of mortgage point(s) / monthly cost savings = breakeven point (in months)
For example, if you have a 30-year $250,000 loan with a 6 percent interest rate, the monthly payment will be $1,498. So, you decide to purchase one point for $2,500 ($250,000 * .01) to reduce the interest rate to 5.75 percent, bringing the monthly payment to $1,458. In this case, the breakeven point would be 62.5 ($2,500 /$40) or around 5 years and 2.5 months.
Assuming you have no issue with staying in your home for at least this span of time, buying points could result in cost savings. But if you plan to move sooner, you’d likely lose money on the deal.
How Much Do Mortgage Points Cost?
Each point is equivalent to 1 percent of the total mortgage.
How Do You Calculate Your Mortgage Points?
To illustrate how this works, assume you want to take out a $550,000 mortgage. You’d pay $5,500 ($550,000 * .01) for one point. Or if you only wanted to purchase one-quarter of a point, you’d pay $1,375 ($550,000 * .0025). Or if you secured a home loan for $325,000, the cost of one point or one-quarter of a point would be $3,250 ($325,000 * .01) and $812.50 ($325,000 * .0025), respectively.
When to Buy Mortgage Points
Buying mortgage points could be sensible in these circumstances:
- You plan to stay in your home for an extended period. A bulk of the monthly mortgage payment goes towards interest at the beginning of the loan, so buying points only make sense if you plan to stay put for a bit.
- You want a more affordable monthly mortgage payment. An interest rate reduction of just 0.5 percent could save you several thousands of dollars over the life of the loan. To illustrate, a 30-year fixed-rate mortgage for $275,000 with a 5 percent interest rate has total interest costs of $256,576. But if the rate drops to 4.5 percent, the total amount you’ll pay in interest is $226,772. If you can afford to buy down the rate by 1 percentage point, you’ll save even more in interest. For example, a 30-year, $350,000 mortgage with a 7 percent interest rate will cost you a total of $838,762, with $488,762 ($838,762-$350,000) accounting for interest paid over the loan term. However, buying down the interest rate to 6 percent means you’ll still pay a hefty sum of $405,708 in interest, but that’s a total cost savings of $83,054 ($488,762-$405,708).
- You don’t plan to refinance soon. Refer to the breakeven point formula referenced above to determine how long it’ll take to recoup the funds spent on buying down the rate. Buying mortgage points could be a smart financial decision if you have no intention of refinancing before the breakeven.
When Not to Buy Mortgage Points
However, you may want to steer clear of mortgage points if:
- You qualify for a competitive interest rate. If your credit score is stellar or you’re planning to make a large down payment, you may score a low interest rate without having to purchase mortgage points. But even if you don’t have excellent credit, a credit score that’s categorized as “good” could be enough to get you a competitive interest rate and save several thousands of dollars.
- You plan to pay your loan off sooner. Making extra payments each month towards the principal can accelerate the repayment of your mortgage. Plus, you’ll pay less in interest since the amount of interest you pay over time is based on the principal balance.
- You’re short on funds. The down payment on a home can take a bite out of your wallet. So, if funds are already low and buying points would create too much of a strain on your finances, forgo the points for now and consider refinancing at a later date to get a better interest rate.
Making the Most Out Of Your Mortgage Points
It is important to consider the total cost associated with paying mortgage points. This includes any applicable origination fees or other costs associated with getting a mortgage loan. By weighing these costs against the potential savings of buying down your interest rate, you can make an informed decision about whether mortgage points are right for you.
Frequently Asked Questions (FAQs)
In a mortgage, 1 point is worth 1 percent of your total home loan amount. To illustrate, if you take out a mortgage for $300,000, one point will cost you $3,000.
A mortgage point, Is It a Good Idea to Buy Mortgage Points?
Buying mortgage points can be a good idea for borrowers planning to stay in their homes for a long time. This is because the upfront cost of the points can be offset by the savings you’ll enjoy from the lower rate over the life of the loan.
Keep in mind that it can take several years to recoup the cost of the points. So, if you plan to sell your home or refinance within a shorter timeframe, the cost of the points may not be worth it.
To determine if buying mortgage points makes financial sense, calculate the breakeven point by comparing the loan estimate with and without points. Consider how long you plan to stay in your home and weigh that against the upfront cost of purchasing points.
If the potential savings from the reduced interest rate will outweigh the cost of the points over the time you expect to live in the home, then buying points might be a wise move for you.
Two points on a mortgage are worth 2 percent of the total amount you borrow for a home loan. For example, if you take out a mortgage for $400,000, two points will cost you $8,000. This would typically result in a greater reduction in your interest rate compared to purchasing just 1 point, which in turn means a lower monthly mortgage payment and substantially lower borrowing costs.
Keep in mind that the specific reduction in interest rate for each point purchased can vary by lender. As mentioned above, it’s essential to calculate the breakeven point and compare loan estimates to ensure that purchasing additional points will provide a financial benefit over the long term.
