Mortgage shoppers often are bewildered by the dizzying array of fees when comparing offers, and no fee gets more attention than mortgage points. They’re quite simple, really, once you break them down, so let’s demystify them once and for all.
Points are a fee that the originator of the mortgage loan charges that take the form of a given percentage of the actual mortgage loan amount. When you “buy points” you are actually paying to lower the loan’s interest rate. Every point costs 1% of the mortgage loan amount, and generally lowers the interest rate of the mortgage by 0.125% to 0.25%. To figure out what each point is worth, simply multiply the mortgage amount by .001.
So, for example, if your mortgage amount is $275,000, each point costs $2750.00. If your lender charges you two points, that fee would add up to a total of $5,500. Paying the points upfront knocks 0.250% to 0.50% off the life of the loan, a pretty powerful consideration as you sit down to finalize your purchase.
Mortgage points can be confusing because points can vary widely from lender to lender and even from one loan offer to another from the same lender. Some loans feature no mortgage points, while other loans might incur a fee of as much as 5-7 points. In some cases, you can even decide how many points you would like to pay for a specific loan option. Lenders generally offer borrowers the option of paying for up to 3 points to lower interest rates.
Like mortgage interest, points are tax deductible. The IRS has a series of guidelines (available at available at http://www.irs.gov/publications/p936/ar02.html) to help you determine whether you can take the deduction in the same year you purchase the house or you have to deduct the cost over the term of the loan. In the latter case, if you sell the house, you claim any remaining deduction in the sale year.
This is why it’s generally not a good idea to buy points if you’re refinancing rather than purchasing a new home: generally when refinancing, points are not fully deductible in the year you pay them unless they are paid in connection with the purchase or improvement of a home. This means that refinancers must write points off in fractional amounts over the life of the loan, greatly reducing any tax benefit upfront.
Find Your Break Even Point
It might seem odd at first glance to choose to pay any mortgage points at all, but you must keep in mind that points are really just interest you are paying in advance on your mortgage loan. This means that the more points you pay upfront at closing, the lower interest rate you can lock in for the life of the loan.
Buying points may make sense if:
- You are getting a fixed-rate mortgage
- You’re planning to be in the home for many years
- Paying points doesn’t come at the expense of lowering your down payment or eliminating any emergency savings on hand
- You plan to be in your home long enough for the up-front cost to equal the savings you get on your monthly payment, called the break even point.
There is a bit of strategy involved in how many points you choose to pay at closing. If you have the cash on hand and you plan to stay in your home for several years or longer, it makes a lot of sense to pay as many points as you can and benefit from a lower monthly payment for the life of your mortgage loan. It’s not at all unusual for buyers to pay 2-3 points up front, and at a ballpark rate of 0.125% per point, generate savings of three-quarters of a point on their mortgage interest rate.
The trick is to come up with a good estimate of the breakeven point where your initial investment in mortgage points pays off in comparison to the reduction in your monthly payment. To calculate how many points you should purchase to save money over the term of your mortgage:
1. Find out what your monthly mortgage payment will be if you do not purchase any points and what your monthly mortgage payment would be if you bought one or more points.
2. Subtract the lower monthly payment from the higher monthly payment to find out how much you would save each month.
3. Divide the amount the points cost by the amount of money you would save each month.
The result is the number of months you will have to live in the house to break even and regain the money you spend on the points.
Let’s use an example to illustrate this process. In this scenario, you have two loan offers on the table:
Loan A: a loan of $250,000 at 5% and zero points
Loan B: a loan of $250,000 at 4.5% with 2 points
You know that each point is 250,000 x .001 = $2500.00, so the cost of 2 points would be $5,000.
Step One: Find out what your monthly mortgage payment will be if you do not purchase any points and what your monthly mortgage payment would be if you bought one or more points.
Loan A: monthly payment of $1,342.05
Loan B: monthly payment of $1,266.71
Step Two: Subtract the lower monthly payment from the higher monthly payment to find out how much you would save each month.
Loan A-Loan B = $75.34 a month.
Step Three Divide the amount the points cost by the amount of money you would save each month.
$5000.00/$75.34 = 66.6
So you find that it would take 66 months, or five and a half years for the savings in monthly payments to equal the cost of the 2 points. That means that if you think you will remain in your house more than 5 years, paying the points makes financial sense.
If your loan-to-value ratio allows for this, you can even finance the mortgage points by increasing your mortgage amount by the value of the mortgage points. This will cause a slight increase in your monthly payment amount, so be sure that the lower interest rate is worth paying more to roll the mortgage points into your loan amount. It’s also worth noting that wrapping points into a mortgage will change the way you can deduct them for tax purposes. You must have paid the points out of your own funds at the time of closing to qualify for the deduction, so it’s wise to speak with a tax professional if you’re considering this option.
Finally, before you decide to buy points, ask yourself to what other purpose the money could be directed. If the money you would pay for points is your emergency fund, paying for points up-front is not going to look like a good idea in retrospect if an emergency pops up. If you will need the money before you can earn and save it back, spending it on points may cause you to have to take out a loan later.
You could argue that money spent on buying points would be better invested in the markets to generate a higher return than the amount saved by paying for the points. But, for many homeowners, the savings generated by buying points outweighs the potential benefit that may be accrued if they managed to select the right investment. Knowing that you saved a half-point or more every time you send in that mortgage payment may very well be more important to you.