The mortgage process is as long and intricate a process as they come. Anyone who has bought a house and went through the motions to get their first home can tell you, it is not an in and out deal. At the tail end of the process, closing your mortgage loan can be arduous, but it is during closing that much of the most important parts of your mortgage loan deal takes place.
Aside from all of the paperwork and closing costs, closing is also a home buyer’s last chance to get a lower interest rate on their new home loan. Many borrowers who don’t fit into the first time home buyer category have discussed mortgage points with their lenders at closing. While purchasing mortgage points means forking out more cash at closing, they help reduce the amount of money you’ll need to come up with for those pesky monthly payments.
So what are mortgage discount points? Let's take a closer look.
Mortgage Point Basics
Mortgage points, sometimes known as discount points, are prepaid portions of interest on your home loan that when purchased, reduce your monthly interest rate. To put it another way, they are fees paid to a lender at closing in exchange for lower interest, and by extension, a lower monthly payment.
It is common practice in the home finance industry to refer to the purchasing of mortgage points as “buying down the rate”. While it is a great way to knock down the interest rate, it does require more upfront money at closing, which is already a sore spot for many home buyers. Besides which, purchasing mortgage points isn’t always worthwhile for every home buyer, but we’ll go into more detail on that later.
What is a Mortgage Point?
One mortgage point is typically worth 1% of the total loan amount. Simplified, it amounts to $1,000 for every $100,000. A savvy home buyer can already see how purchasing multiple points can drastically raise closing costs. For example, a home worth $200,000 would mean one mortgage point costs $2,000! So how do these points affect your rate of interest?
Generally speaking, purchasing one mortgage point reduces your interest rate by .25% (actual amounts may vary depending on the lender, so keep in mind that this is not a set statistic, it is just the most commonly used increment).
Therefore, If you have an interest rate of 3.75%, and purchase one mortgage point, then your interest rate would decrease to 3.5%. Purchasing two points would lower the rate to 3.25%, and so on and so forth. Lenders typically allow the purchase of up to three discount points.
Negative Mortgage Points
Sure, mortgage points are pretty common. What many home buyers don’t know, is that negative mortgage points also exist. Sometimes referred to as rebates or yield spread premiums, negative mortgage points work like regular mortgage points, with a slight twist.
With negative mortgage points, the lender pays some of the fees associated with your home loan in exchange for a higher rate of interest that you must be responsible for. The value of a negative mortgage point remains the same as with its positive counterpart. As does the increments of interest by which your rate will increase.
For example, if the lender pays $2,000 worth of fees for you on a home loan worth $200,000 (one mortgage point), then the interest rate on the home loan would increase by .25%.
Negative mortgage points are perfect for home buyers who have trouble coming up with the money to cover a down payment or any other fees due at closing. Having the lender handle some of those fees can greatly reduce the out of pocket expenses that many home buyers face. The catch is that your monthly mortgage payments will be more than they were originally supposed to be.
When Purchasing Mortgage Points Makes Sense
As we’ve mentioned before, mortgage points won’t always be worth buying. As a matter of fact, their high costs are enough to steer most home buyers away. Even borrowers who could easily afford them shouldn’t blindly purchase them just because they can. After all, they are an investment.
It all boils down to when you will break even on your investment when it comes to mortgage discount points. Breaking even in this sense means regaining the cost of the points themselves in savings. There is a simple formula to follow, that should be checked before purchasing any mortgage points, and all you need to know is the amount of savings on each monthly payment from purchasing mortgage points, and the total cost of the points you wish to purchase.
To determine how long it would take for you to break even, simply divide the total cost of the mortgage points you wish to purchase by the monthly savings amount. What you are left with is the length of time in months of how long it would take to recoup the cost of the mortgage points.
This calculation is essential to weighing whether or not purchasing mortgage points will be worthwhile. It is important to note that the length of your loan term plays a crucial role in this as well. If you only break even shortly before the loan term is over, then it wasn’t really worth the high upfront cost.
The general rule of thumb is that the longer the loan term (or rather, the longer you own the house), the more the mortgage points will accumulate savings over the life of the loan. Purchasing points isn't done to simply break even, it is done to save money, after all.
Once you have your break even point, know the length of your loan term (or how long you plan on owning the home past that point), and figure out how much you can afford to spend at closing, it is up to you to decide whether or not it will be worth it. Lower monthly payments alone are always welcome, but at the cost of each point, it is a hard hit to take for many home buyers. Remember, mortgage points accrue savings slowly, and take time before they begin to show true value.
Mortgage Points and Taxes
Adding value to the concept of buying down your rate, is the fact that in most cases, mortgage points are tax deductible. So long as they are purchased for a primary or second home, mortgage points can be deducted from your yearly taxes, under two conditions:
The home must be collateral for a loan used to purchase, build or improve that same home.
The cost of the mortgage points must be paid directly to the lender in full, not using borrowed money.
Mortgage Points: In Review
So there you have it. Buying down your rate by purchasing mortgage points can be pretty awesome if you’re entering a mortgage agreement for the long haul. For those who can afford to do so, just make sure you are willing to push past the break even point and truly reap some savings.
If you are already fretting about coming up with the funds to cover closing costs, then mortgage points are not for you. However, negative mortgage points would definitely soften that huge financial blow. Just expect to pay more each month over the life of the loan.