Should I Buy Points on My Mortgage?

Mortgage points are an option to lower your interest rate when securing a home loan. They are essentially prepaid interest paid at closing in exchange for a lower interest rate over the life of the loan. Buying points involves an upfront cost for potential long-term savings, requiring careful evaluation of your financial situation and housing plans.

Understanding Mortgage Points

Mortgage points are a fee paid to the lender at closing, typically calculated as a percentage of the total loan amount. One point equals 1% of the loan value; for example, one point on a $300,000 mortgage costs $3,000. These points reduce the interest rate, a practice known as “buying down the rate.”

It is important to differentiate between two types of points: discount points and origination points. Discount points are specifically paid to reduce the interest rate. Origination points are fees charged by the lender for processing the loan itself, and they do not directly lower the interest rate. While both are paid upfront at closing, discount points are the focus when considering whether to buy down your interest rate.

Lenders offer various options for purchasing points, ranging from fractions of a point to several full points. Each point typically lowers the interest rate by approximately 0.125% to 0.25%. The exact reduction can vary by lender and loan product. Paying for these points is an upfront expense included in the closing costs of the mortgage.

For tax purposes, discount points paid on a mortgage for a primary residence may be deductible as home mortgage interest. The Internal Revenue Service (IRS) generally allows for the deduction of the full amount of points in the year they are paid, provided certain conditions are met. Limitations on the deductible amount may apply if the loan amount exceeds $750,000.

Calculating the Financial Impact

Understanding the financial impact of buying mortgage points requires calculating both the upfront cost and the subsequent monthly savings. The cost of points is straightforward: if one point equals 1% of the loan amount, a $400,000 loan with one point would incur a $4,000 cost. Two points on the same loan would cost $8,000. This upfront payment is made at closing.

To determine the monthly interest savings, compare the monthly mortgage payment with and without the points. For instance, consider a $300,000, 30-year fixed-rate mortgage. If the initial interest rate is 7.0%, and paying one point reduces it to 6.75%, the monthly principal and interest payment will decrease. This reduction represents the direct savings gained from buying points.

As a specific example, a $300,000 loan at 7.0% interest over 30 years would have a monthly principal and interest payment of approximately $1,995. If one point costing $3,000 reduces the rate to 6.75%, the monthly payment might drop to around $1,947. This difference of $48 per month is the immediate financial benefit. These calculations allow a borrower to quantify the direct benefit of a lower interest rate against the initial outlay.

Determining the Break-Even Period

A key element in deciding whether to buy mortgage points is determining the “break-even period.” This period represents the length of time it takes for the cumulative monthly interest savings to equal the initial upfront cost of the points. If a homeowner stays in the home for longer than this period, the savings from the reduced interest rate will eventually exceed the cost of the points, making the investment financially beneficial.

The formula for calculating the break-even period is simple: divide the upfront cost of the points by the monthly interest savings. For example, if buying points costs $3,000 and results in a monthly savings of $48, the break-even period would be approximately 62.5 months ($3,000 / $48). This means it would take about 5 years and 3 months for the monthly savings to recover the initial investment.

Consider another illustration: on a $400,000 mortgage, if two points cost $8,000 and reduce the monthly payment by $75, the break-even period would be roughly 106.7 months ($8,000 / $75), or about 8 years and 10 months. A longer break-even period suggests that the financial benefit of buying points will take more time to materialize.

Multiple factors influence this calculation, including the loan amount, the cost per point, and the exact interest rate reduction achieved. Lenders offer different rate reductions for each point purchased, typically ranging from 0.125% to 0.25% per point. Therefore, it is important to obtain precise figures from a lender to accurately determine the break-even point for a specific loan scenario.

Key Considerations for Your Decision

Beyond the break-even period, several other practical factors influence the decision to buy mortgage points. The length of the mortgage term plays a significant role. A 15-year mortgage, for instance, has a shorter repayment schedule than a 30-year mortgage, meaning there is less time to realize the long-term savings from a reduced interest rate. While monthly payments are higher on shorter terms, the total interest paid over the life of the loan is considerably less, which can sometimes diminish the relative benefit of buying points.

The amount of time a homeowner plans to stay in the home is equally important. The break-even period is only relevant if the homeowner intends to remain in the property longer than that calculated duration. If circumstances lead to moving or refinancing before reaching the break-even point, the upfront cost of the points may not be recouped through interest savings, potentially resulting in a net financial loss.

Available cash reserves are another consideration. Buying points requires a significant upfront payment at closing, typically between 2% and 6% of the loan amount for total closing costs. While discount points may be tax-deductible, this deduction typically occurs in the year the points are paid. It is prudent to ensure sufficient cash is available for the down payment, closing costs, and points, without depleting emergency funds or other essential savings.

The current interest rate environment can also influence the attractiveness of buying points. In periods of high interest rates, securing a lower rate through points can lead to substantial long-term savings, making the investment more appealing. Conversely, when rates are already low, the incremental savings from buying points might be less impactful. Finally, consider the opportunity cost: the money used for points could potentially be allocated elsewhere, such as a larger down payment to avoid private mortgage insurance (PMI), home improvements, or other investments that might offer a higher return.