This comprehensive guide will help you explore all your potential questions and queries related to mortgage points, including a detailed discussion that will help you decide whether you should opt for these points or not.
One of the most useful investments of all time includes purchasing a house or a piece of land. This type of investment is actually helpful for not only you, but also your future generations as it provides a form of security.
But what happens if you really want to make this purchase but lack the financial stability to do so?
Simple, you opt for a mortgage loan! This type of loan can not only help you raise funds, but also assist in breaking down payments so that you can pay them easily.
However, many of us are not familiar with the structure of mortgage loans that we could possibly use for our benefit. One of these includes the usage of mortgage points that eventually might end lowering your overall cost of loan.
But what is it and how does it work? So many questions pop up when we hear these two words, “mortgage points”. So, to find out answers to all of your queries and assumptions, stay with us because this guide contains everything you need to know about mortgage points!
Table of Contents
- 1 What are mortgage points?
- 2 What are mortgage origination points?
- 3 Are mortgage points worth it?
- 4 Should you opt for mortgage points?
- 5 Conclusion
What are mortgage points?
Mortgage points, also known as discount points, is a common part of the structure of mortgage loans. It basically includes paying some “fees” to your lender before you close your deal, in exchange for lower interest rates.
As a result, this lower interest rate not only reduces your monthly payments, but might also end up helping you save a good amount towards the end of your mortgage term.
Important terminologies used in mortgage points
This is basically the number of years or duration for your mortgage contract. Usually, it is 15 years or 30 years. However, it can vary according to every contract.
This is the total home loan or the total balance for your mortgage. In other words it is also called loan principal.
This is the annual amount charged on top of the principal payment by the lender for giving the loan.
The table below shows the average mortgage interest rates as of 26 August 2021 according to different terms.
|30-Year Fixed Rate||3.050%|
|20-Year Fixed Rate||2.880%|
|15-Year Fixed Rate||2.350%|
This is the amount that you as a borrower need to pay to your lender on a monthly basis. It is divided into two parts: principal and interest. Principal amount is what you borrow from a lender and need to pay back. Whereas interest is the extra money that you will have to pay to your lender for giving you a loan. Thus, summation of both these parts will give us a monthly amount that you need to pay.
How are mortgage points used?
Generally, each mortgage point is 1% of your total mortgage amount. For example, if your total mortgage amount is $200,000, then one point will be equal to $2,000 (1% of $200,000).
Thus, if one mortgage point is equal to $2,000 then if you purchased two points it will cost you $4,000 and so on. Typically, 1 point reduces interest rates by 0.25% which in return reduces your monthly payments. However, to actually figure out if purchasing mortgage points is helping you out or not, you need to find the breakeven point. A breakeven point helps you define how long it will take for you to recover the cost of purchasing these points. After finding the duration you will need to recover the cost, you can easily understand if you are saving money or not.
Example of mortgage points
Let’s work on an example using the figures that we mentioned above.
Assume that you took a loan of $200,000 on a 30 year old fixed rate mortgage. The interest rate charged on this loan principal is 4%. Now according to the amortization schedule, you will need to pay $954.83 monthly (the calculation can easily be done through an online amortization calculator).
So now if you wish to purchase two mortgage points, that means it will cost you $4,000 (since each point will be equal to $2,000 as calculated above). And if one point reduces the interest rate by 0.25%, then as a result your interest rate will be 3.5%. Now if you again calculate your monthly payments, it will be $898.09.
Thus, this way we can clearly see that the monthly payments have reduced by $56.
However, the calculation doesn’t end here. As discussed above, we also need to find out our breakeven point in order to see how long it will take to recover our cost of purchasing these mortgage points.
Since you spent $4,000 to purchase mortgage points, and are now saving $56 every month, you need to divide $4,000 by $56, to find out when you will recover this cost. This division gives us the number 71, meaning that it will take 71 months (5.9 years or simply almost 6 years) to recover the cost of purchasing mortgage points.
In addition to this, when using the online amortization calculator to find out the monthly payments, you must have also seen the “total interest paid” amount. Thus, to find out our lifetime savings, we need to use this amount.
When the interest rate was 4%, and the mortgage loan was $200,000 the total interest paid was $143,739.01. However, when the interest rate was reduced to 3.5% (after the purchase of mortgage points), the total interest paid was $123,312.18. This means that if you opt for purchasing mortgage points, you will end up saving $20,427 over the mortgage term.
Varieties of mortgage points
There are two varieties of mortgage points: positive points and negative points.
When it comes to positive mortgage points, these are simply what we discussed above. You pay for a point, and in return you get a decrease in your interest rates. So in easy to understand words, here you are buying down the interest rate by paying up front.
However, in the case of negative mortgage points (also known as no cost mortgage) it is the opposite. Over here, the lender pays a portion of mortgage fees and in return they increase your interest rates. In other words, the lender ends up removing your up front payment or fees to help you afford to close the mortgage, and as a result, you have to pay higher monthly payments.
What are mortgage origination points?
This is another type of mortgage point that operates a little differently. Over here, mortgage origination points simply represent the fees that the borrowers pay to the lender to originate, evaluate, process and approve the loan.
Generally, one mortgage origination point equals 1% of the total mortgage or loan amount. However, the number of points can vary from lender to lender.
So, if the lender charges 2 points on a $200,000 mortgage, then the borrower must pay 2% of $200,000, that is, $4,000.
Discount vs. mortgage origination points
Since discount points tend to reduce the interest paid, as discussed above, we can call it “prepaid interest” to some extent. On the other hand, origination points are costs that the borrower pays in order to get that loan from the lender.
While discount points are tax deductible as it is used for the mortgage, the origination points are not tax deductible. This is because it includes the fee that is used for inspection and research purposes, and according to the IRS (Internal Revenue Service), such cost is not tax deductible.
Are mortgage points worth it?
In order to decide whether anything is worth it or not, one must compare its pros or cons. This is because there can be a possibility that something that is a great opportunity for someone else, might not turn out so well for you. Thus, after understanding what are mortgage points, you must go through its advantages and disadvantages to further assist your decision.
Advantages of mortgage points
Decline in monthly payments
As we discussed above in our example, typically, 1 point reduces interest rates by 0.25% which in return reduces your monthly payments. Thus, if you purchase 2 points, your interest rates will drop by 0.5%. So if before mortgage points your interest rate was 4%, now it will be 3.5%. As a result, the lower the interest rate, the lower the monthly payments. In the example, with a 4% interest rate, you would pay $954.83 monthly if your loan amount was $200,000 on a 30 year old fixed rate mortgage. However, with an interest rate of 3.5%, the monthly payments would be $898.09. This way, every month you get to say $56 if you opt for purchasing mortgage points.
Savings in long term
In the example above, apart from monthly savings, we also discussed the total amount we will save throughout our mortgage contract. This means the difference in the total interest that will be paid at the two interest rates (4% and 3.5%). As discussed, if we don’t purchase 2 mortgage points, our interest rates will stick to 4%, and as a result, total interest paid throughout the term would be $143,739.01. Whereas, if we buy 2 mortgage points, the interest rates will fall to 3.5% and the total interest paid throughout the term would be $123,312.18, helping us save around $20,427 during the contract.
Interest rates can rise
Since usually there tends to be a lot of uncertainty in the financial markets, interest can fluctuate, that is, go up and down. If your contract hasn’t locked a rate, then you might suffer due to a rise in interest rate because at times, the rates keep on rising. Thus, in such a scenario, the best option is to lock the interest rates at the lowest possible late so that you can avoid being a target to such uncertainties.
They are tax deductible
One of the most important features of mortgage points is that they are tax deductible. Even though this condition may vary, according to the IRS (Internal Revenue Service), all costs that are used for the mortgage and not for closing costs, are tax deductible. This is why mortgage discount points are applicable to this case, and not mortgage origination points.
Disadvantages of mortgages points
Interest rates can go down
Just like interest rates can go up, they can also go down. In this case, if interest rates are not fixed you will be at a disadvantage if you end up purchasing a mortgage point. This is because the amount you paid to mortgage points could be saved if the interest rates were going to fall either way. Thus, instead of immediately purchasing interest rates, you could wait and watch for the interest rates to fall. However, this can be a risk since interest rates can fluctuate, and go either up or down.
Paying up front for points
When you are purchasing mortgage points, you pay a sum of money up front. Like discussed in the example above, for 2 mortgage points you will end up paying $4,000 up front. This means that you will lose $4,000 at one go, which could have been used for other purposes. For example, in case you come across an emergency, and you have already used up your savings to pay for mortgage points, then you will be in trouble. As a result, to pay for that emergency you might have to take a loan from family or friends. Thus, this might not be an ideal situation.
Moving/refinancing before the breakeven point
We discussed in the example above that a breakeven point is a point that tells us how long it will take for you to recover the cost of purchasing these mortgage points. As a result, if you decide to move out of the house or refinance your loan before you reach the breakeven point, then you will be at a loss as at the end, you will have paid more in points than you saved up by reducing your interest. Therefore, in such a case, purchasing mortgage points will bring you at a disadvantage.
Should you opt for mortgage points?
Well, after having a thorough discussion on what are mortgage points, we need to decide who should opt for it and who should not.
The first thing to consider in this case is to look at the payment of points. Can you afford it? And if you can, are you putting your savings at risk? Will you have enough money for emergencies after paying up front in mortgage points? If you can afford it, and don’t need another loan to pay up front, and are not spending all of your savings, then mortgage points will benefit you! However, if the case is vice versa, then you should think again.
Another important consideration is the amount you spent in purchasing mortgage points, could that be used elsewhere? Meaning, could you invest it in the stock market, and gain a higher return instead? If so, then purchasing mortgage points is again not a very good idea.
As a result, before making any decision, you must consider the total mortgage amount, the area the house is in, your savings, your job situation, and the chances of a promotion or pay raise. Only after weighing these options can you come up with a decision.
After this comprehensive discussion, some of you might think that purchasing mortgage points is the best choice for you, whereas some of you might feel the opposite. Either way, there is nothing to worry about. This is because no financial decision is easy to make, and it is better to know everything from top to bottom, instead of making a bad choice.
Therefore, do not hurry. Use the online calculators available and calculate all the possibilities you might come across. As a result, this way, you will not only understand your situation better, but will also be able to make a smart choice.