Mortgage points: What are they and how do they work?

Buying a house is the most expensive purchase most of us will ever make, so naturally, anything that can reduce the cost of a mortgage is worth looking at. Besides negotiating a good price and shopping for the best mortgage rates, some homebuyers buy mortgage points.

Also called “discount points,” they’re basically a way to lower your interest rate — for a fee. Let’s look more closely at mortgage points, how they work and when it’s smart to use them.

What are points on a mortgage?

Points on a mortgage act as prepaid interest that are due at closing. The amount you pay upfront in mortgage points effectively buys down the interest rate you will pay over the course of your loan. One mortgage point typically costs 1 percent of your original loan’s principal.

What are mortgage points?

Mortgage points are the fees a borrower pays a mortgage lender in order to trim the interest rate on the loan, thus lowering the overall amount of interest they pay over the mortgage term. This practice is sometimes called “buying down the interest rate.”

Each point the borrower buys costs 1 percent of the mortgage amount. So, one point on a $300,000 mortgage would cost $3,000.

In effect, mortgage points are a type of prepaid interest. By buying these points, you reduce the interest rate of your loan, typically by 0.25 percent per point. You can often buy a fraction of a point or up to as many as three whole points — sometimes even more.

By reducing the loan’s interest rate, you can lower your monthly payment. However, keep in mind that this requires an upfront payment. Typically, the longer you plan to live in a home, the more benefit you’ll get from paying for points.

Discount points vs. origination points

Mortgage points that lower your interest rate, also known as “discount points,” are not to be confused with origination points — another type of mortgage point.

Origination points don’t affect the interest rate on your loan, and they are not discretionary, but mandatory. They are origination fees a lender charges to create, review and process your loan. Like its discount cousin, one origination point typically equals 1 percent of the total mortgage. So, if a lender charges 1.5 origination points on a $250,000 mortgage, the borrower must pay $3,750. Typically, you pay your origination points as part of your closing costs when you finalize your home purchase.

Not all lenders charge origination points on their mortgages. Some lenders allow borrowers to get a loan with no- or reduced-closing costs or origination points; however, they often compensate for that with higher interest rates or other fees.

You can also sometimes negotiate origination points. Homebuyers who come to the table with a 20 percent down payment and a strong credit score have the most significant negotiating power, as lenders will reduce origination points to entice well-qualified buyers.

How do mortgage points work?

Each mortgage discount point typically lowers your loan’s interest rate by 0.25 percent, so one point would lower a mortgage rate of 4 percent to 3.75 percent for the life of the loan. How much each point lowers the rate varies among lenders, however.

The rate-reducing power of mortgage points also depends on the type of mortgage loan and the overall interest rate environment. When you explore buying points, mortgage lenders should tell you the specifics.

Borrowers can buy more than one point, and even fractions of a point. A half-point on a $300,000 mortgage, for example, would cost $1,500 and lower the mortgage rate by about 0.125 percent.

You’ll pay for the points at closing, and they’re listed on the loan estimate document, which you’ll receive after applying for a mortgage, and the closing disclosure, which you’ll receive a few days before closing the loan.

How much can you save by paying mortgage points?

If you can afford to buy discount points on top of the down payment and closing costs, you will lower your monthly mortgage payments and could save lots of money. The key is staying in the home long enough to recoup the prepaid interest. As we mentioned before, if you sell the home after only a few years, or refinance the mortgage or pay it off, buying discount points could lose you money.

Here is an example of how discount points can reduce costs on a $320,000, 30-year, fixed-rate mortgage with 20 percent down:

Loan principal: $320,000	Without points	With points
Interest rate	7.0%	6.5%
Discount points cost	$0	$6,400
Monthly payment (principal and interest)	$1,703	$1,618
Lifetime total interest paid	$357,293	$326,584
Lifetime savings	N/A	$30,709

In this example, the borrower bought two discount points, with each costing 1 percent of the loan principal, or $3,200. By buying two points for $6,400 upfront, the borrower’s interest rate shrank to 6.5 percent, lowering their monthly payment by $85, and saving them $30,709 in interest over the life of the loan. (However, to save that full amount, the borrower would have to live in the home for the full term of the loan, 30 years, and never refinance.)

How to calculate the breakeven point

“The added cost of mortgage points to lower your interest rate makes sense if you plan to keep the home for a long period of time,” says Jackie Boies, a senior director of Partner Relations for Money Management International, a nonprofit debt counseling organization based in Sugar Land, Texas. “If not, the likelihood of recouping this cost is slim.”

To calculate the “breakeven point” at which you’d recover your outlay on the prepaid interest, divide the cost of the mortgage points by the amount the reduced rate saves each month. Using the example above:

calculator

$6,400 / $85 = 75 months

This shows that our borrower would have to stay in the home for about 75 months, or just over six years, to recover the cost of the discount points.

You can use Bankrate’s mortgage points calculator and amortization calculator to figure out whether buying mortgage points will save you money.

Should you buy down your interest rate?

Buying mortgage points is a way to pay upfront to lower the overall cost of your loan and reduce your monthly payment. It makes the most sense in a few cases:

• If you plan to be in the home for a long time: Because buying points on mortgage loans reduces the rate for the life of the loan, every dollar you spend on points goes further the longer you pay that mortgage. As a result, if you plan to be in the house for a while, the amount you’ll save each month is likely to make the upfront cost worth it. It will also take several years to break even on that upfront cost. (Conversely, if you don’t plan to stay in a home for a long time, paying points is likely to lose you money overall.)

• You’re already putting 20 percent down: If you are, you’re avoiding private mortgage insurance (PMI) and likely getting the best interest rate the lender can offer you. If you haven’t hit the 20 percent mark on the down payment, though, putting money there rather than into points will likely still lower your interest rate, and possibly by a larger margin. That’s because a bigger down payment lowers your loan-to-value ratio, or LTV, which is the size of your mortgage compared with the value of the home.

• You don’t plan to refinance anytime soon: Even if you plan to stay in the house for a while, the current environment of relatively high interest rates may have you considering a refi down the road. Refinancing will change your mortgage interest rate, so if you think that could be in your future, it may be prudent to skip buying points mortgage-wise now.

Ultimately, consider all the factors that could determine how long you plan to stay in the home with that mortgage. These factors might include the size and location of the property, your job situation and the current mortgage rate environment. Then, figure out how long it would take you to break even before buying mortgage points.

How to compare mortgage loan offers

Looking at the annual percentage rate (APR) of your mortgage can help you compare loans with different rates and point combinations. The APR incorporates not just the interest rate, but also the points you pay and any fees the lender will charge, so it can give you more clarity and help you more easily compare apples to apples.

You can decide whether to pay points on a mortgage based on whether this strategy makes sense for your situation. Once you get a quote from a lender, run the numbers to see if it’s worth paying points to lower the rate for the length of your loan.

Discount point FAQ

• Should you buy down your interest rate as mortgage rates rise?

  Mortgage rates remain elevated, which might make mortgage points seem more attractive to many borrowers. However, the breakeven point remains five-plus years. In other words, the benefits of paying points will only be realized if you expect to have the loan longer than five years.

• How are mortgage points factored into advertised rates?

  Whether you find a rate on a mortgage lender’s website or through a third party, the mortgage rates you see advertised might or might not include points. One rate might even seem attractively low, but that could be due to points already factored in that you might not want to pay. So be sure to check the listing’s fine print.

• Are mortgage points tax-deductible?

  Mortgage discount points are tax-deductible on up to $750,000 of mortgage debt for homeowners who bought property after Dec. 15, 2017, or up to $1 million for those who purchased before that date. Origination points are not tax-deductible, as they’re considered charges for services, not homebuying expenses.