Filing Your Income Taxes
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 are used to “buy down” the interest rate on a mortgage. One mortgage point represents 1 percent of the mortgage amount.
For example, if you have a mortgage for $250,000, then one point would be $2,500. If your mortgage is $400,000, then one point equals $4,000.
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. If you have a mortgage rate of 4 percent, buying one point could reduce that rate to 3.75 percent. The actual amount of reduction varies by lender and 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.
Read More: What Is the Difference Between a Mortgage & a Lien?
Why Buy Mortgage Points?
You buy mortgage points to get a lower interest rate and reduce your monthly mortgage payment. Let’s take an example.
Suppose you are 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 When Buying Mortgage Points?
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?
In our example, you paid $8,000 to get the monthly payment reduced by $114. If you divide $8,000 by the monthly savings of $114, you find that it takes 70 months to reach breakeven.
If you stay in your house for longer than 70 months, you're ahead of the game. However, if you sell your house or refinance your mortgage before reaching the break-even point, you lose money by buying the additional two points.
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. For each month you're in your house after break-even, you gain savings. If you only plan to stay in your house for a few years, 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 your budget is tight, buying points to lower your monthly payment can make a mortgage more affordable by lowering your debt-to-income ratio. This is particularly true if your credit score isn't high enough to qualify you for the best and lowest rates available.
If you have sufficient cash balances, putting extra money into points may give you a larger tax deduction upfront.
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 need for closing. You have to be careful not to deplete your savings and checking accounts when 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.
In addition, 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, therefore, is a questionable proposition.
Should You Buy Points or Make a Larger Down Payment?
Each borrower’s situation is different because they are 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 (PMI). 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 per year.
Are Mortgage Points Tax Deductible?
If you itemize your deductions, the mortgage points you pay may be deductible in the year paid. However, the IRS has a long list of qualifications that you must meet in order to deduct mortgage points.
See IRS Topic No. 504 Home Mortgage Points for more specific information.
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. It improves 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.
If you plan on moving in the next four to six years, you're probably not going to reach the break-even point that justifies purchasing mortgage points. However, by staying in your home past the break-even point, you gain savings each month until you either refinance or pay off the loan.
Recognize that when you purchase a house, you may need cash to buy furniture and make improvements. It’s just human nature. It may make more sense to conserve your cash and lower your interest costs by making an extra monthly payment, for example, $50, towards the principal balance on the loan.
- Internal Revenue Service:Topic No. 504 Home Mortgage Points
- Internal Revenue Service: Home Mortgage Interest Deduction
- Smartasset: When Should You Pay Points on a Mortgage?
- Nerdwallet: Mortgage Calculator: ‘Should I Buy Points?’
- Nerdwallet: What Is a Mortgage Origination Fee?
- Bankrate: Mortgage Points and How They Can Cut Your Interest Costs
- Ramsey: What Are Mortgage Points and How Do They Work?
- Rocket Mortgage: Mortgage Points: What Are They and Should You Buy Them?
- Nerdwallet: Mortgage Points: Should You Pay These Optional Fees?
- Internal Revenue Service. "Topic No. 504 Home Mortgage Points." Accessed Nov. 3, 2020.
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.