Buying a house is one of the most expensive and complicated purchases that anyone can make. The options and negotiation for the amount of the down payment, fixed-rate mortgages or variable interest rates, closing costs, mortgage points and lender origination points all add to the complex calculations.
Does it make sense to “buy down” your interest rate? Are the points tax deductible? Do the tax benefits make these mortgage points worth it to you? Let’s examine the advantages and disadvantages of paying for mortgage discount points.
What Are Mortgage Discount Points?
Mortgage points are fees paid to a lender to give you a lower interest rate on a home mortgage. They're used to “buy down” the interest rate on a mortgage. One mortgage point represents 1 percent of the mortgage amount. For example, one point would be $2,500 if you have a mortgage for $250,000. One point equals $4,000 if your mortgage is $400,000.
The amount that one mortgage point reduces your interest rate is not fixed. Generally, a lender will reduce the rate by 0.25 percent for one point, but it could be more or less than that. Buying one point could reduce the rate to 3.75 percent if you have a mortgage rate of 4 percent. The actual amount of reduction varies by lender and by the status and direction of the interest rate market.
Buying mortgage points doesn't always mean that you pay exactly 1 percent. You could buy 1/2 a point or a combination of points, such as 2 1/2 points.
Points are paid when you close on your mortgage. They're originally listed in two places: on the Loan Estimate document for closing costs that you receive when you apply for a mortgage and on the Closing Disclosure document that lists all the final fees.
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Why Buy Mortgage Points?
You buy mortgage points to get a lower interest rate and to reduce your monthly mortgage payment. Suppose you're offered a $400,000 mortgage with an interest rate of 4 percent payable over 30 years. A quick calculation shows the monthly payment would be $1,910 with principal and interest.
Now the lender offers you the option to pay two points and reduce your interest rate to 3.5 percent. The points would cost you $8,000, but how much would this change your monthly payment? A revised calculation of the monthly payment with the lower interest rate shows the amount would be reduced to $1,796, a reduction of $114 per month in your monthly payment.
Is paying $8,000 in points worth getting this reduction in monthly payments? Let's look at a break-even analysis to get an answer.
What Is the Break-Even Point?
The idea behind break-even analysis is to find out how long it takes for the accumulated monthly savings to equal the amount you paid for the points. In other words, how long does it take to recoup your investment in mortgage points?
You paid $8,000 to get the monthly payment reduced by $114 in our example. You'll find that it takes 70 months to reach the break-even point if you divide that $8,000 by the monthly savings of $114.
You're ahead of the game if you stay in your house for longer than 70 months. But you'll lose money by buying the additional two points if you sell your house or refinance your mortgage before reaching the break-even point.
Read more: How Do I Pause a Mortgage?
When to Purchase Mortgage Points
It pays to buy mortgage points if you plan to stay in your house past the break-even point. You gain savings for each month you're in your house after you break even. It probably makes better sense to pay the lower closing cost, accept the higher monthly payments and use your cash to make a larger down payment on the next house if you only plan to stay in your home for a few years.
Buying points to lower your monthly payment can make a mortgage more affordable by lowering your debt-to-income ratio if your budget is tight. This is particularly true if your credit score isn't high enough to qualify you for the best and lowest rates available.
Putting extra money into points may give you a larger tax deduction upfront if you have sufficient cash balances.
Paying for discount points makes little sense if you refinance your mortgage before reaching the break-even point or slightly thereafter. You won't have time to recover your investment from buying the points.
Buying mortgage points increases the cash you'll need for closing. You have to be careful not to deplete your savings and checking accounts when you're making a down payment and paying closing costs.
What About Adjustable-Rate Mortgages?
Adjustable-rate mortgages usually have fixed rates for only five or seven years. This may or may not be long enough to reach the break-even point to justify buying discount points.
Depending on the trend of interest rates, persons with adjustable-rate mortgages may refinance into a fixed rate before reaching the break-even point. Buying down rates on adjustable-rate mortgages is therefore a questionable proposition.
Should You Buy Points or Make a Larger Down Payment?
Each borrower’s situation is different because they're dealing with different lenders. You have to do the calculations and negotiate with the lenders to determine the effects of buying down the mortgage rate or increasing your down payment to get a lower loan amount. One advantage of an increased down payment is that you'll have more equity in your home.
One issue to consider is private mortgage insurance. Not buying discount points and putting the money toward a larger down payment may eliminate the need for PMI, which can cost about 1 percent of your mortgage balance per year.
Are Mortgage Points Tax Deductible?
The mortgage points you pay may be tax deductible in the year paid if you itemize your deductions. But the IRS has a long list of qualifications that you must meet in order to claim the deduction. The points can't be more than the amount that's common for the area in which you're buying. The property has to be your primary residence. Numerous other rules also apply.
What Are Origination Points?
Unlike mortgage discount points, which lower your interest rate, origination points are simply a way for your lender to cover expenses for administrative and closing costs. They improve the lender’s profit on the loan. Fortunately, origination fees can be negotiated, especially if you have good credit and are making a substantial down payment. Unfortunately, origination points are not tax-deductible.
Whether you purchase mortgage discount points or not comes down to two issues: how long you plan to stay in your house, and how much cash you have in savings. You're probably not going to reach the break-even point that justifies purchasing mortgage points if you plan on moving in the next four to six years. But you gain savings each month until you either refinance or pay off the loan by staying in your home past the break-even point.
Keep in mind that you may need cash to buy furniture and make improvements when you purchase a home. It may make more sense to conserve your cash and lower your interest costs by making an extra monthly payment toward the principal balance on the loan.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.