Is It Worth Buying Points on a Mortgage?

Mortgage points are an upfront fee paid to a lender in exchange for a lower interest rate on a home loan. This decision prompts a question: is paying these additional costs at closing a financially sound strategy? Understanding the mechanics and implications of mortgage points can help clarify whether this investment aligns with your financial circumstances and goals.

Understanding Mortgage Points

Mortgage points, often called “discount points,” are prepaid interest paid to a lender at closing. Each point typically costs one percent of the total loan amount. For instance, on a $300,000 mortgage, one point would cost $3,000. These points reduce the interest rate for the loan’s entire term.

The interest rate reduction from purchasing points is usually small, commonly around 0.25 percentage points per point. For example, one point might lower a 7.00% interest rate to 6.75%. This upfront payment aims to decrease the total interest paid over the loan’s life and reduce monthly mortgage payments.

It is important to distinguish discount points from “origination points.” Origination points are fees charged by the lender for processing the loan, such as underwriting and administrative costs. Unlike discount points, origination points do not reduce the interest rate and are generally not tax deductible. This article focuses on discount points, as they directly address whether buying down the interest rate is a worthwhile financial decision.

Calculating Your Return on Investment for Mortgage Points

Determining if buying mortgage points is financially beneficial involves calculating the “break-even point.” This point is when accumulated savings from lower monthly payments equal the upfront cost of the points. To calculate this, you need the total cost of the points, the interest rate without points, and the interest rate with points.

First, calculate the monthly payment for the loan without points using the higher interest rate. Next, calculate the monthly payment with points, reflecting the lower interest rate. The difference between these two monthly payments represents your monthly savings. Finally, divide the total cost of the points by this monthly savings amount. The result is the number of months it takes to recoup your initial investment.

Consider a $300,000 mortgage loan with a 30-year term. Without points, a 7.00% interest rate results in a monthly payment of approximately $1,996. If you purchase one point for $3,000 (1% of $300,000), the interest rate might drop to 6.75%, reducing your monthly payment to about $1,946. Your monthly savings would be $50 ($1,996 – $1,946). To find the break-even point, divide $3,000 by $50, which equals 60 months, or five years. Any savings realized after this 60-month period represent a net financial gain.

Key Considerations for Your Mortgage Point Decision

While the mathematical break-even point is a starting point, personal circumstances significantly influence whether buying mortgage points is a sound decision. Consider the anticipated length of time you plan to stay in the home. If you expect to sell or refinance before reaching the calculated break-even point, you will not fully recoup the upfront cost, resulting in a financial loss. Conversely, the longer you intend to keep the mortgage, the more time you have to realize savings from a lower interest rate, making points more beneficial.

The prevailing interest rate environment also plays a role. In periods of high interest rates, buying points can provide a more substantial reduction in the monthly payment, making the investment more appealing. However, if interest rates are already low, the impact on your monthly payment might be less significant. Your available cash reserves are another practical consideration. Points are paid at closing, adding to the immediate financial outlay alongside the down payment and other closing costs. It is advisable to have sufficient liquid funds to cover these upfront expenses without depleting emergency savings or compromising other financial priorities.

Finally, consider your overall financial goals. Some homeowners prioritize lower monthly payments to manage their budget, while others prefer to preserve cash at closing for other investments or home improvements. Evaluating how buying points aligns with your broader financial strategy and comfort level with upfront expenses helps in making an informed decision.

Tax Treatment of Mortgage Points

The tax treatment of mortgage points can add another layer to the financial analysis, as certain points may be deductible. For points paid on a loan to buy or build a main home, they are generally deductible as prepaid interest in the year they are paid. To qualify for this immediate deduction, the loan must be secured by your principal residence, paying points must be an established and customary business practice in your area, the amount paid for points should not exceed what is generally charged, and the funds must come from you, not borrowed from the lender.

If you do not meet all the criteria for deducting points in the year paid, or if the points are for a different type of loan, the deductibility rules change. For points paid on a refinance, a home equity loan, or a second home, the deduction must typically be spread out equally over the life of the loan. For example, if you paid $3,000 in points on a 30-year refinance, you would generally deduct $100 per year.

A notable exception for refinances occurs if a portion of the refinanced mortgage proceeds is used to improve your main home; in such cases, the points related to the home improvement portion may be fully deductible in the year paid. These deductions are typically available only if you itemize on Schedule A (Form 1040) of your federal income tax return. Consulting with a qualified tax professional is advisable to understand the specific implications for your individual situation.