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Should You Pay Points? Mortgage Discounts Demystified

Kimberly Rotter

If you're buying or refinancing a home, you may have the chance to lower the interest you pay by purchasing mortgage points. It may seem like a great way to cut the overall cost of your loan, but keep in mind it carries some drawbacks. Here's what you should know before you decide.

What Are Mortgage Points?

Mortgage points are fees you pay to your mortgage lender at the time of closing in exchange for a reduced interest rate on your loan. The mortgage lender benefits from this transaction by receiving cash upfront instead of collecting incremental interest payments over time, while you benefit from having a lower interest rate.

[Read: The Best Mortgage Lenders of 2018.]

In the mortgage industry, points are also known as discount points, buy-down points or discount fees.

How Much Do Mortgage Points Cost?

Each point is an upfront payment that costs 1 percent of the total loan amount. For example, one point on a $250,000 loan would cost $2,500. Most lenders allow borrowers to buy fractional points -- for example, $1,250 for half a point.

What Are Origination Points?

Mortgage discount points are not the same as origination points, although both may appear on your closing statement.

Origination points, also called origination fees, cover some of the costs of the loan, including fees charged by the loan officer or broker and others who work to execute the loan. Like with mortgage discount points, each origination point costs 1 percent of the total loan amount. Not all lenders charge origination points, and for those that do, the amount varies.

How Do Points Affect Your Mortgage Interest Rate?

Purchasing a point will remove a fraction of 1 percent from your interest rate. The exact interest rate reduction varies from lender to lender, but a 0.25 percent reduction per point is a good estimate. Lenders offer smaller interest rate discounts for fractional points -- for example, a half-point could buy you a 0.125 percent interest rate discount.

"There is not necessarily a limit on the number of discount points a borrower can pay, but realistically, there may be a point of diminishing returns where an increase in discount points doesn't reduce the interest rate enough to benefit the borrower," says Kris Yamamoto, senior vice president of corporate communications at Bank of America.

The option to pay hard cash today in exchange for future savings may sound confusing. If you're considering this option, think about how 0.25 percent compounds over time. Here's what the monthly payment and total interest charges look like on a fixed-rate, 30-year mortgage for $250,000, depending on the interest rate:

Interest rate
Monthly payment (principal plus interest)
Interest charges over the life of the loan
4.75 percent
4.5 percent
4.25 percent

If your lender offers to lower your interest rate by half a percent, from 4.75 to 4.25 percent, in exchange for two points, you save nearly $22,000 (when you factor in the upfront cost of $5,000) over the life of the loan.

In this situation, a fraction of a percent really adds up. Anything you can do to chip away at your interest rate upfront can save significantly over time. This is why discount points are worth serious consideration.

When Does It Make Sense to Buy Points?

Buying discount points will save you money only if you make payments on the loan for long enough to reach the break-even point. In its most simplistic form, the break-even point is when the total amount of money you have saved through a reduced interest rate is equal to the amount you paid upfront for discount points. After the break-even point, the more payments you make, the more money your discount points will save you.

In the example above, the monthly payment drops by $74.27 when the rate is reduced from 4.75 to 4.25 percent. This means that you would need to make regular monthly payments on your loan for at least 68 months (saving about $5,050) in order to save more money than you spent on points ($5,000). At that time, you will begin to see a net financial gain.

The longer you hold the loan, the more you will save with an interest rate reduction using points. If you sell the property or pay off the loan in month 68, your $5,000 investment will net you $50.36 in actual savings. But if you sell the property after 10 years, you will net nearly $4,000 in savings. And if you sell after 20 years, you will save almost $13,000.

You will lose money if you purchase discount points and pay off your loan before the break-even point.

Other factors can impact your break-even point, such as your tax bracket, which affects how much you will save with your mortgage interest deduction, and the opportunity cost associated with the cash you use to pay for the points.

The break-even point is not the only way to gauge the value of a rate buy-down. In a low-rate market, if you secure an even lower rate by paying points, you may reduce the likelihood that you will need to refinance your loan. In that case, the fees you pay for points may be lower than what you would have paid to refinance your loan.

Another angle to consider is whether buying points will leave you short on the down payment. "If you need to decide between making a 20 percent down payment and buying points, make sure you do the math," says Yamamoto. "If you make a lower down payment, you may be required to carry private mortgage insurance [PMI]. Check to see if this additional cost would cancel out the benefit you'd get from buying points and lowering your interest rate."

Should You Pay for Points on an Adjustable-Rate Mortgage?

"Points for adjustable-rate mortgages [ARMs] typically provide a discount on the loan's interest rate only during the initial fixed-rate period," says Yamamoto. "Run the numbers to ensure that your break-even point occurs before the fixed-rate period expires."

The break-even point for 0.25 percent incremental discounts often falls between the four- and six-year marks. Many ARMs see their first adjustment at the five-year mark, so it's especially important to calculate the break-even point on this type of loan before paying for discount points. The initial rate period must be longer than the break-even point, or paying for discount points won't be worth it.

Should You Finance Points?

The decision to buy points often depends, at least in part, on the amount of cash you have on hand to make the purchase. Since not all buyers have the cash to buy down their rate, the lender may offer to roll the cost of the points into the loan balance. This may be a good idea for some customers but not for all.

[Read: The Best FHA Loans of 2018.]

Financing points means borrowing money, at interest, in order to reduce interest payments on other money borrowed at interest.

This strategy has some potential pitfalls:

-- When you finance discount points, you eliminate a portion of the savings those points were meant to incur. The loan balance and monthly payment will be a little higher, pushing your break-even point further into the future.

-- Financing discount points might jeopardize your loan eligibility. Certain loan programs, including Federal Housing Administration and Veterans Affairs loans, may not exceed certain dollar limits. If borrowing money to pay for discount points puts your loan balance above the limit for your area, you may become ineligible for the loan program you are applying for. The single-unit loan limit may be as low as $294,515. The limits increase in high-cost areas.

-- Financing discount points increases the loan-to-value ratio, or LTV, on your mortgage. Limits vary by lender, but generally, if your LTV ratio is greater than 80 percent, your lender will require private mortgage insurance, or PMI. Even if you are already subject to PMI, increasing your LTV by financing points can increase your monthly PMI premiums. Saving money on interest charges doesn't make sense if it leads to other costs that are equal or greater.

Are Points Tax-Deductible?

The short answer is yes: Points paid for your primary residence are still tax-deductible in 2018.

Here are the basic things you need to know about deductions for regular home loans:

-- Like other forms of prepaid interest, mortgage points are tax-deductible, up to IRS limits, when you itemize on Schedule A. By itemizing, you can deduct whatever interest you pay on the first $750,000 of your mortgage debt. If your mortgage debt does not reach $750,000, then you can deduct all of it.

-- On a new home purchase, the cost of mortgage points is fully deductible within one year of closing the loan.

-- If you finance mortgage points, they are deductible within the first year after you purchase them if what you pay in cash at closing is higher than the cost of the points themselves. Otherwise, the points are deductible over the life of the loan, just like regular interest.

In the case of a refinanced mortgage loan:

-- You can generally deduct points over the entire loan term. In the year you refinance, you can also take any deductions you did not yet take on the original loan's points.

-- You can deduct the interest on up to $1 million in refinanced mortgage debt as long as the original mortgage began before Dec. 14, 2017.

-- If you borrow additional funds and use them to make significant improvements to the home, and you meet other IRS requirements, a portion of your points may be deductible in the year you purchase them.

What Are Negative Discount Points?

While most discount points are positive, meaning they lower your interest rate by raising your closing costs, you can also buy negative discount points, which lower your closing costs by raising your interest rate.

In essence, negative discount points are a cash rebate from your lender in exchange for a higher interest rate, which means you'll have more money right now at greater cost over the life of the loan. Offering negative discount points is one way that some lenders are able to advertise mortgages with no closing costs.

The upside to this arrangement is that you will have more cash in hand when you close your loan. The downside is that you will have to pay back, with interest, all the money you saved upfront.

Negative points make the most sense if you want the lowest possible closing costs on your mortgage. They can help a borrower get a loan for little or no closing cost, which may be preferable to rolling costs into the loan and increasing the loan balance as a result.

Should I Pay for Points?

Financial wisdom says that you should take the loan that costs the least. But the reality is that you must take the loan that meets your needs right now.

"If you are deciding whether or not to pay discount points, ask yourself these questions: How long do you plan on living in this property, and how much do you have available to pay upfront?" says Manny Delgadillo, regional diverse segments consultant at Wells Fargo Home Lending. "We have to look at the customer's whole financial picture and advise that customer to buy down the rate only if it makes sense, depending on how long it would take to recoup the cost."

[Read: The Best Bad Credit Loans of 2018.]

Although the fictional borrower in the earlier example saved nearly $22,000 over 30 years, buyers in the U.S. typically stay in their homes for only 10 years, according to a 2017 report from the National Association of Realtors. Many homeowners move even more often. To determine whether discount points are worth the cost, calculate your financial benefit and break-even point in the context of your own plans for moving or selling.

If you are short on cash, you may need to take negative points for closing cost relief. But if your debt-to-income ratio is close to the limit, you may need to buy points to bring your monthly payment down.

Ask about points if your lender or broker doesn't mention them, and then you can run the numbers to see if buying points makes sense for your situation.

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