Should You Pay Points On Your Mortgage?

Mortgage points represent an upfront fee paid to a lender in exchange for a lower interest rate on a home loan, effectively reducing the overall cost of borrowing over time. This decision involves weighing an immediate expense against long-term savings on monthly payments. Understanding whether paying points aligns with your financial goals and homeownership plans is important.

Understanding Mortgage Points

Mortgage points are fees paid at closing, with one point equaling 1% of the total loan amount. For instance, on a $300,000 mortgage, one point would cost $3,000. There are two primary types of mortgage points: discount points and origination points.

Discount points are paid to reduce the interest rate on your mortgage. Their main purpose is to lower your interest payments and, consequently, your monthly mortgage payment. Origination points, conversely, are fees charged by the lender to cover the administrative costs of processing and underwriting the loan. While they are also expressed as a percentage of the loan amount, origination points do not reduce your interest rate.

The Mechanics of Mortgage Points

Paying discount points directly impacts the interest rate applied to your mortgage, reducing it by approximately 0.125% to 0.25% for each point purchased, though this reduction can vary by lender and market conditions. For example, if a lender offers a 6.5% interest rate, paying one point might lower it to 6.25%. This reduction in the interest rate translates into a lower monthly mortgage payment, leading to potential savings over the loan’s term.

Points are paid upfront at the loan closing as part of your closing costs. They are listed as “prepaid interest” on loan documents like the Loan Estimate and Closing Disclosure. In some instances, particularly with refinances or if you have sufficient home equity, the cost of points might be rolled into the loan amount, meaning you would pay them back over time.

Key Considerations for Paying Points

Deciding whether to pay points involves several considerations, as these fees represent a long-term investment. One primary factor is how long you anticipate staying in the home. Since points are an upfront cost, the financial benefit of a lower interest rate accrues over time, making them more advantageous for borrowers who plan to keep their mortgage for an extended period. If you sell or refinance before reaching the break-even point, you might not recoup the initial investment.

The current interest rate environment also plays a role in this decision. When prevailing rates are high, paying points to secure a lower rate can be appealing. However, if rates are expected to drop significantly in the near future, you might consider if refinancing would occur before you realize the full benefit of the points paid.

Another consideration is the availability of upfront cash. Paying points requires a substantial sum at closing, which could otherwise be used for a larger down payment, establishing an emergency fund, or other investments.

The loan term influences the impact of points, as the savings from a lower interest rate are spread across the life of the loan. Points offer greater cumulative savings on longer-term loans, such as 30-year fixed mortgages, compared to shorter terms. The tax implications of paying points can influence their overall value. Discount points are considered deductible as home mortgage interest. For a mortgage on a primary residence, they can be deducted in the year paid, provided specific IRS conditions are met, including that the points are a percentage of the loan amount and are customary in the area. However, if the mortgage amount exceeds $750,000, the deductibility of interest, including points, may be limited.

Determining Your Break-Even Point

Calculating the break-even point is a step in deciding if paying points is financially sound. This calculation reveals how long it will take for the savings from a reduced interest rate to offset the upfront cost of the points.

The break-even point is determined by dividing the total cost of the points by the monthly savings achieved due to the lower interest rate. For example, consider a $300,000 mortgage. If paying one point, which costs $3,000, reduces your monthly payment by $49, the break-even point would be approximately 61 months ($3,000 / $49), or about 5 years and 1 month. This means you would need to keep the mortgage for at least this long to recoup the initial expense. If you stay in the home longer than the break-even period, you will realize net savings over the remaining term of the loan. Conversely, if you anticipate selling or refinancing before reaching this point, paying points might not be the most cost-effective decision.

Exploring Options Without Points

Choosing not to pay mortgage points means accepting a higher interest rate on your loan. This option results in lower upfront closing costs, preserving more of your cash at the time of purchase or refinance.

For individuals with limited available cash, avoiding points can be a choice, allowing funds to be allocated towards a larger down payment, emergency savings, or immediate home expenses.

This approach can be suitable for borrowers who foresee selling their home or refinancing their mortgage within a few years. If a borrower plans to move or refinance before the break-even point for points is reached, the higher upfront cost of points would not be recovered through interest savings. Therefore, not paying points aligns with short-term homeownership plans or situations where immediate liquidity is prioritized over long-term interest rate reduction.