Is It a Good Idea to Buy Points on a Mortgage?
Navigate the complex decision of buying mortgage points. Learn how to evaluate upfront costs vs. long-term savings for your home loan.
Buying points on a mortgage can be a strategic financial decision for homeowners, potentially leading to savings over the loan’s life. This involves paying an upfront fee to a lender for a lower interest rate. Understanding how mortgage points function and their long-term implications is key to deciding if this strategy benefits your financial situation.
Understanding Mortgage Points
A mortgage point is a fee paid to a lender, typically at closing, that represents one percent of the total loan amount. For example, on a $300,000 mortgage, one point costs $3,000. These points are essentially a form of prepaid interest, allowing borrowers to secure a lower interest rate on their loan.
It is important to differentiate between “discount points” and “origination points.” Discount points reduce the interest rate. Origination points are fees charged by the lender for processing the loan application and do not lower the interest rate.
Paying discount points upfront results in a reduced interest rate for the loan’s duration. This lowers each subsequent monthly mortgage payment. These fees are generally paid at closing, becoming part of the overall closing costs.
Calculating the Breakeven Point
Determining the financial advantage of buying points involves calculating a “breakeven point.” This is the period it takes for monthly savings from a lower interest rate to offset the upfront cost of the points. This calculation helps ascertain how long a borrower needs to keep the mortgage to recoup the initial investment.
To calculate, first identify the total cost of the points. Next, calculate the difference in monthly mortgage payments with and without the points. For example, on a $300,000 30-year fixed-rate mortgage, an interest rate of 7.00% results in a monthly principal and interest payment of approximately $1,995.63. If one point ($3,000) lowers the rate to 6.75%, the monthly payment becomes roughly $1,946.09, yielding a monthly savings of about $49.54.
To find the breakeven point, divide the total cost of the points by the monthly savings. In this example, $3,000 divided by $49.54 equals approximately 60.56 months, or just over five years. This means after about 61 months, accumulated savings from lower monthly payments will equal the initial cost of the points.
Mortgage points paid for a loan on a primary residence may be tax-deductible in the year they are paid, provided certain Internal Revenue Service (IRS) criteria are met. These criteria include the points being a customary practice in the area, not exceeding typical charges, and the borrower using the cash method of accounting. For refinances or second homes, points are generally deducted over the life of the loan. This potential tax deduction effectively reduces the net cost of the points, making the breakeven period shorter than a simple calculation might suggest.
Key Considerations for Your Decision
Beyond the breakeven point, several personal and financial factors influence the decision to buy mortgage points. The most significant consideration is the borrower’s expected loan tenure. While the breakeven calculation provides a timeline, individual plans for how long to stay in the home and keep the mortgage are important.
A borrower’s financial liquidity also plays a role. Paying points requires an upfront cash outlay, which should not deplete emergency savings or hinder other financial goals, such as retirement contributions or debt repayment. Assess whether funds used for points could be better utilized elsewhere, such as for a larger down payment to reduce the overall loan amount, or for investments that might yield a higher return.
The prevailing interest rate environment should also be considered. In a period of high interest rates, securing a lower rate through points might offer more substantial long-term savings. Conversely, when rates are already low, the incremental savings from buying points might be less impactful.
Ultimately, purchasing mortgage points is a personal decision, requiring a holistic view of one’s financial situation. It involves weighing the immediate cost against potential long-term savings, considering both quantitative analysis and personal circumstances.