Mortgage Points Explained…Finally
Most Common Questions About Mortgage Points
Mortgage points are fees that are paid at the time of closing to the mortgage lender for a lower interest rate on the home loan…which is where the phrase “buying down the rate” comes from. Because the interest rate is such a large part of the monthly mortgage payment, mortgage points can sometimes be referred to as “discount points”.
Now here’s where it gets mathematical: Each point costs one percent of the mortgage amount. However, the actual rate reduction varies by loan and lender. Typically each point will lower the interest rate by one-quarter to one-half of a percent, but to make the decision on whether to pay for points, your lender needs to give you the exact amount that each point lowers the interest rate. Also keep in mind that it may be possible to purchase partial points. Buying a half point, for example, would cost half a percent of the loan amount and would result in the interest rate being reduced by half of the amount that a full point would.
It is the borrowers option whether to purchase points or not. However, there are cases when the seller can issue a credit that can also be used to pay for mortgage points. This “rate buy-down” strategy is something that a real estate agent and/or mortgage professional can advise you on.
The longer you intend on owning the home, the more beneficial a rate reduction will be. So, if you aren’t planning on keeping the home for long, then buying down the rate doesn’t make much sense. Similarly, if you may refinance soon, it doesn’t make sense to pay for points. See our breakeven point assessment to see if it makes sense in your scenario.
Generally, mortgage points are tax deductible as they are considered prepaid interest. However, before you state your mortgage point deduction, pay attention to these requirements:
– The mortgage must be used to buy or build your primary residence
– The points must be a percentage of your mortgage amount
– The use of points must be a normal business practice in your area
– The amount of points paid must not be excessive for your area
– You must use cash accounting on your taxes
– The points must not be used for items that are typically stand-alone fees, such as property taxes
– You cannot have borrowed the funds to pay for the points from the mortgage lender or broker
– The amount you pay must be clearly itemized as points on your statement
It depends on the loan program, but keep in mind there are no bulk discounts when buying points…so after a certain number, buying points just doesn’t make financial sense.
No the cost of a mortgage point is always a one percent of the loan amount. The amount of reduction in interest rate is dictated by the lender and isn’t negotiable. The negotiable part is whether you can get your seller to give you a closing cost credit that you could then use to buy mortgage points.
Mortgage points must be paid as part of the closing costs and can’t be financed.
For adjustable rate mortgages, buying points typically only reduces the loan’s interest rate during the initial fixed-rate period.
The Mortgage Break-even Point
In order to really nail down whether paying for points makes financial sense, it’s good to know your break-even point. The break-even point is when the savings from the lower interest rate match the cost of the points. If you don’t stay in the mortgage beyond the break-even point, you’re losing money by paying for mortgage points. The hard part is calculating how long you’ll actually have the mortgage because (just like a box of chocolates) life is unpredictable. So we’re gonna get a bit deep and offer a few life questions that may help you navigate whether paying for mortgage points is the right call:
- Are there life events that could require you to upsize or downsize your property before you hit your break-even point? Examples include getting married, having kids, retiring, or taking care of a relative.
- Are there financial events that may allow you to get a better interest rate on a mortgage before you hit your break-even point? Examples include a financial windfall, paying off a significant debt, payment delinquencies falling off your credit report, or other events that may improve your credit score.
- Are there any plans to take on a large financial commitment such as property renovation or other major purchase before you hit your break-even point?
- Does the mortgage you’re taking out include mortgage insurance (PMI)?
If you answered no to all of these, then it’s likely that paying discount points to lower your rate would make a lot of sense. If you answered yes to just one or more of these, you may want to look into your crystal ball and ask what’s the level of certainty that any of the above life events would really occur before your break-even point hits? Of course, a mortgage professional (ahem!) can help assess the different scenarios and then you can decide if paying for mortgage points is the right decision for your situation. When in doubt, we err on the side of passing on the discount points. After-all, we’d rather eat our chocolates with a bunch of extra cash in hand because we paid significantly less in closing costs.
Speaking of extra cash, if you are getting a conventional mortgage and paying less than 20 percent as a down payment, you are probably paying mortgage insurance (PMI). Yes, we’ve entered the math and acronyms portion of the lesson, so it’s time to take a deep breath and remember that if any of this isn’t clear, we’re right here to clarify. The main point is that: the larger your down payment the lower your mortgage insurance. So if your downpayment is below 20 percent and you are considering buying points, have your lender give you the exact amount of added mortgage insurance you are incurring by spending your cash on those discount points. That extra PMI may eat into the monthly savings you thought you’d get from a lower rate.
The Mortgage Rate Buy Down
While buying points with your own cash may not always make sense, using closing cost credits from the seller are a whole different story. These seller credits are an ideal way to buy mortgage points and lower the interest rate. This approach is particularly useful when buyers and sellers can’t come to an agreement on the purchase price. Getting the seller to agree to a closing cost credit for the buyer to buy down the interest rate, can result in a lower monthly payment than if the seller just reduced the purchase price by the same amount. That’s because the interest payment is often such a major portion of the total monthly payment. Amongst mortgage and real estate pros, this strategy is called a Seller Buy-Down…and often it’s a true win-win. Well worth the mathematical back flips you’re going to have to make your lender and agent perform to pull it off.
Also, using closing credits for buying down the rate is common with job relocations because often the employer is making contributions towards closing costs.
Lastly, remember that if you’re talking to multiple lenders and comparing rates, make sure you’re taking points into consideration. If one lender is quoting a rate that requires mortgage points to be paid, then it’s not accurate to compare it to another lender’s rate without mortgage points. So, in your best New York City wise guy voice, yell: we’re talkin’ apples to apples here!
We hope this helps…and as with all things in life, feel free to contact us with any questions!
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