What Are Points in Finance and How Do They Work?

Points are a common term in the mortgage industry, representing upfront fees paid at closing. They can lower interest rates or compensate loan officers for originating a loan. Understanding how they work helps borrowers make informed decisions.

While points can reduce monthly payments or provide tax deductions, they require an upfront cost that may not always be beneficial. The key is determining when paying for points leads to long-term savings.

Mortgage Discount Points

Mortgage discount points allow borrowers to lower their interest rates in exchange for an upfront payment. Each point typically costs 1% of the loan amount and reduces the interest rate by about 0.25%, though this varies by lender and market conditions. For example, on a $300,000 mortgage, one point would cost $3,000 and might lower the interest rate from 7% to 6.75%.

The decision to buy points depends on how long a borrower plans to stay in the home. The breakeven point—the time it takes for monthly savings to exceed the upfront cost—determines if purchasing points makes sense. If a borrower saves $50 per month from a reduced rate and pays $3,000 for a point, it would take five years to break even. Those expecting to sell or refinance sooner may not benefit.

Market conditions influence this decision. When interest rates are high, borrowers may be more inclined to pay for a lower rate. In a low-rate environment, the savings may not justify the cost. Some lenders offer temporary rate buydowns, often paid by sellers or builders, which reduce payments for the first few years rather than permanently lowering the rate.

Origination Points

Origination points are fees lenders charge for processing a mortgage, covering administrative costs and compensating loan officers. Unlike discount points, these fees do not reduce interest rates. They typically cost around 1% of the loan amount. For example, on a $250,000 mortgage, one origination point would be $2,500.

Borrowers may be able to negotiate these fees. Some lenders waive them in exchange for a slightly higher interest rate, effectively rolling the cost into monthly payments. This can reduce upfront expenses but often results in higher overall interest payments.

Loan type and borrower profile also influence origination fees. Government-backed loans, such as FHA and VA loans, have different fee structures. VA loans cap lender compensation to prevent excessive charges. Borrowers with strong credit may qualify for reduced fees, while those with complex applications may face higher costs due to increased underwriting requirements.

Tax Treatment of Mortgage Points

The IRS allows mortgage points to be deducted as prepaid interest if certain conditions are met. The loan must be used to buy, build, or improve a primary residence, and the points must be a percentage of the loan amount rather than a flat fee. They must also be common practice in the borrower’s area, paid directly by the buyer, and not covered by lender credits or seller-paid costs. If these criteria are not met, deductions must be spread over the life of the loan rather than taken in the year paid.

Refinancing adds complexity. Points paid on a refinanced loan generally cannot be deducted in full during the year of payment. Instead, they must be spread out over the loan term. For example, if $4,500 in points were paid on a 30-year mortgage, only $150 per year could be deducted. However, if the loan is paid off early—whether through refinancing again or selling the home—any remaining undeducted points can be deducted in full that year. The same rule applies to home equity loans, but deductions are only allowed if the borrowed funds are used for home improvements.

Property investors face different tax treatment. Points paid on rental properties must be amortized over the loan term rather than deducted immediately. However, they are considered a business expense, which can offset rental income and reduce taxable profits. Investors should also be mindful of how these deductions interact with depreciation rules, as miscategorizing expenses can lead to IRS scrutiny.