When you borrow money to buy a home, you are required to pay interest on the loan amount. Interest is the fee that the mortgage lender charges for providing the funds to purchase your house. Your interest rate (or mortgage rate) is affected by a number of factors, including current national mortgage rates and your strength as a borrower. However, it’s also important to note that the mortgage rate you obtain can be affected by your ability to purchase mortgage points up-front.
What Is a Mortgage Point?
There are two main types of mortgage points: origination points and discount points. The first type, origination points, doesn’t do much in terms of lowering your loan’s mortgage rate. But for those who are interested in low mortgage rates, discount points can actually help reduce the amount you pay interest. Discount points are paid in addition to your down payment and other loan costs.
One mortgage point is equal to 1.0% of the principal mortgage balance. If you are borrowing $185,000 to buy a house, one discount point would equal $1,850. However, it’s important to note that one mortgage point does not mean your mortgage rate will drop from 5.0% to 4.0%. In reality, a mortgage point is more likely to lower your mortgage rate by one-quarter or one-eighth of a percentage. If the original mortgage rate was 5.0%, paying one point would lower the mortgage rate to approximately 4.75% or 4.87%. Thus the more points you pay, the lower your mortgage rate can be (and the more interest you can save).
Should You Pay Mortgage Points?
Many homebuyers believe that it’s worthwhile to pay mortgage points up-front. If you plan on staying in that home for a long period of time (7 years or more), paying points to lower your mortgage rate could result in tens of thousands of dollars in savings over the life of your loan. However, you will need to have the extra cash to pay points up-front in order to make this work.
Another reason that homebuyers choose to pay discount points to reduce their mortgage rate is because of the tax advantage. The IRS permits a tax deduction for mortgage points over a number of years. Some borrowers find that their long-term mortgage plans, along with this tax break, make it worth it to pay the points. [See related article "The Mortgage Interest Tax Deduction"]
However, there are some downsides to paying mortgage points. If national mortgage rates drop in the next few years and you refinance to a lower rate, or even if the market presents an opportunity to equal the rate you get by paying points, then you may have wasted your money. You should also consider how long you plan on staying in that home ― if you live in the home for less than five or seven years, the interest savings may not offset what you paid in points.
While paying points to lower the mortgage rate is useful for many homebuyers, it’s important to carefully go over the numbers and evaluate your particular situation.