Mortgage points are money you pay up front at the time of closing in exchange for a lower interest rate on your home loan. They’re also referred to as “discount points," and the process has been called “buying down the rate.” Buying mortgage points at the time of closing can save some significant money on monthly mortgage payments over the years. Plus, you may find the points tax deductible.
How Do Mortgage Points Work?
Mortgage discount points are something like prepaid interest. Each point you purchase as an upfront cost when you close on a mortgage to buy down the interest rate on your loan by a certain percentage. Your home mortgage interest rate will be lower if you buy one point instead of no points, and even lower if you buy two points rather than one. You can even buy just a fraction of a point. They’re a one-time cash-out-of-pocket expense made to cover the cost of the points, in exchange for reduced mortgage payments for as long as you carry the loan.
Mortgage payments can be comprised of numerous factors: principal toward paying off your loan, homeowners insurance, property taxes and interest on the amount you borrowed. The percentage of interest each point will save you depends on your lender, and these percentages can differ between types of mortgage loans as well. The market at the time you take out your mortgage can have an effect, too.
Read More: How to Calculate Mortgage Interest
How Are Points Calculated?
The cost of points is universal among lenders. Each mortgage point equals 1 percent of the amount you’re borrowing. For example, a single point would cost you $1,750 if you’re taking out a $175,000 mortgage. That $1,750 would typically reduce your interest rate by about 0.25 percent, so you'd pay only 4.25 percent over the life of your loan if you were initially quoted a rate of 4.5 percent.
You might pay $1,750 now, but that will slash each and every one of your mortgage payments by $35 or so. Now assume that yours is a 30-year fixed-rate mortgage. That works out to a savings of $12,600 over the term of your loan: $35 times 360 months (12 months a year for 30 years).
When Do You Pay Points?
Any points you buy are payable at closing, and the money goes to your lender. It’s added to your closing costs, so you have to add them to the check you’re writing on that day. But you’re not prohibited from negotiating a deal with the home seller to pay some or all of your points. This might be an option for you as a homebuyer in a strong buyer’s market with a seller who’s desperate to get their home sold.
The points you and your lender have agreed on, as well as the corresponding interest rate reduction, should appear on the loan estimate you receive at the time you apply for the mortgage, as well as on the closing disclosure, on page 2 in Section A. The closing disclosure should be provided to you a few days before settlement.
Comparing Mortgage Loans
The rate-reducing power of a point is at a lender’s discretion. One lender might cut your interest rate by 0.22 percent for each point, while another will give you 0.26 percent off. Points aren’t regulated by federal law, except to the extent that you must receive some discount on your interest rate in exchange. It’s also possible that a lender will offer a certain percentage to one borrower, and a different percentage to another, or that two separate lenders will offer different percentages to two individuals with the exact same loan qualifications and credit scores.
That said, points are definitely something to inquire about when you’re comparing loans. You also want to make sure that you’re not being offered a really nice interest discount in exchange for higher other fees. Make sure the equation works out in your favor.
When Points Aren’t Really Points
Not all points are points in the true sense of the word. Other loan terms can include the word “points” when, in fact, they’re something else entirely.
Origination points are a prime example. These points are fees you pay to your lender in exchange for processing your home loan. Origination fees are payable at settlement as part of your closing costs, too, and they’re also generally equal to 1 percent of your mortgage amount, but they’re not going to have any effect on your interest rate.
The Consumer Financial Protection Bureau (CFPB) indicates that some lenders have been known to tag any upfront fee that’s based on a percentage of your loan amount as "points." Again, check your loan estimate and closing disclosure so you’re sure you understand what you’re paying, even if you have to take the paperwork to an attorney for further review.
Are Points Right for You?
You might be thinking that paying to get a low rate with tax benefits all sounds like a pretty good deal, particularly if you have the cash on hand to pay a little more at closing. It can be, but as with any transaction, there are pros and cons.
Coming up with that extra cash out of pocket at settlement is probably a solid choice if you’re reasonably sure that you’re going to remain in that home – with that mortgage – for decades. You’ll obviously save much less if you move out or refinance in five years rather than run out the entire 30-year mortgage term. Otherwise, you might want to go ahead and pay a higher interest rate in exchange for some other lender concession or credit at closing.
The CFPB suggests comparing three scenarios: how much you’ll save if you were to sell or refinance in a few years, your savings if you were to remain in place with the same mortgage and monthly payment for the life of the loan, then again based on how long you honestly expect to live there.
Another option is to divide the dollar amount of the points you’re considering paying by the monthly savings in interest. The answer will tell you how long you must stay in the home, with that mortgage, to reach the breakeven point where paying for points begins to make sense. It’s expressed in months, so you’d have to remain in the home without refinancing for almost eight years if the number you arrive at is 95. It works out to 7.91 when divided by 12 months in a year.
And here’s something else to consider: Points are tax deductible if you itemize, and mortgage interest is as well. So when is this tax break going to do you the most good? Will it be more helpful in the year you purchase, or taking a larger deduction annually over a period of time? You’ll want to factor this into your math calculations as well. Keep in mind that a good many rules apply to claiming this tax deduction. For example, the home must be your primary residence, and the points must be clearly noted on your closing disclosure and any disclaimer statements. There are limits to the amount of mortgage debt that qualifies as well.
Read More: Can You Claim Mortgage Interest on Taxes?
The ultimate goal is making your money work for you to the greatest extent possible by negotiating the best mortgage for your circumstances. You can often reduce your interest rate by making a larger down payment, too, and that money buys you more home equity. It doesn’t go into your lender’s pocket.
- Consumer Financial Protection Bureau: What Are (Discount) Points and Lender Credits and How Do They Work?
- IRS: Topic No. 504 Home Mortgage Points
- Navy Federal Credit Union: Understanding Mortgage Points
- Bankrate: Mortgage Points and How They Can Cut Your Interest Costs
- Bank of America Better Money Habits: What Are Mortgage Points?
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.