What Are Mortgage Points & Should You Buy Them?

When you apply for a mortgage, your lender will let you know the interest rate you can expect to pay based on numerous factors, such as your credit score and the amount of your down payment.

You also may be offered the option to pay a little more in closing costs in exchange for a lower interest rate. That extra upfront cost is called mortgage points – sometimes called discount points. This is separate from your down payment and other closing costs, which typically range from 2% to 6% of your loan amount.

Your mortgage banker can help you analyze whether paying mortgage points is worth it to you. It’s a key financial decision during the home financing process that depends on multiple considerations, including how long you plan to own the home, how much cash you want to spend, and whether your primary goal is to lower your monthly payments.

Keep in mind that lender requirements, rate reductions per point and seller-contribution limits can vary — this article is a general guide. Your specific terms will depend on your loan program, lender and the current market.

What Are Mortgage Points?

Mortgage points are fees that you pay to your lender to lower your mortgage interest rate, which is often referred to as buying down the interest rate or a mortgage buydown. You pay points at closing, and they will appear as a line item on your Loan Estimate and Closing Disclosure.

One mortgage point costs 1% of your mortgage loan amount and typically reduces your interest rate by about 0.25%. You can buy more than one point or less than one point.

For example, if you’re borrowing $400,000 to buy a home, one point might cost $4,000. Depending on market rates, your mortgage rate would be reduced from 6.75% to 6.50%.

How Do Mortgage Points Work?

When you pay mortgage points upfront, you’re essentially pre-paying some of the interest you would otherwise pay over the life of your loan. You’re locking in a lower rate for your loan term, which does two things: First, the lower mortgage rate reduces your monthly payment. Second, this lowers the total interest you pay over time.

If you have the cash upfront to buy points, you can buy any amount you and your lender agree on – it can be 0.5 points, 2 points or 1.375 points – up to the maximum allowed, usually one to four points.

While the typical reduction in your interest rate is 0.25% per point, the specific rate reduction varies by lender. Your lender will provide you with a Loan Estimate with your loan terms, which you can review and verify again on your Closing Disclosure.

Mortgage points may be tax deductible if you itemize your federal income taxes since they are prepaid interest. Consult a tax advisor for individualized advice.

To deduct discount points in the year you paid them, the IRS generally requires that the points were paid on a loan to buy or build your primary residence, that paying points is customary in your area, and that the points were not paid in place of other closing fees. If you refinance, you typically deduct the points over the life of the loan rather than all at once. Because tax rules can be complex, consult a tax professional for advice specific to your situation.

Can I Roll Mortgage Points Into My Loan?

In most cases, no — mortgage points must be paid upfront at closing and cannot be financed into your loan balance. However, some loan programs allow you to roll origination fees into the loan. If you’re short on cash, your banker can walk you through whether lender credits might be a better fit for your situation.

Discount Points vs. Origination Points: What’s the Difference?

The term “points” can refer to either discount points or origination points, which are easy to confuse since both appear as part of your closing costs.

Discount points are optional points that you can use to buy down the rate. Origination points refer to the fee a lender charges to generate and underwrite your loan. Origination points don’t impact your mortgage rate.

While both types of points typically are a percentage of your mortgage balance, they serve different purposes. Some lenders don’t charge origination fees at all, but they may charge you a slightly higher interest rate in return for eliminating the fee.

This is why it’s important to ask your lender about any points on your Loan Estimate and Closing Disclosure: make sure you understand what type of points you’re paying and their impact on your mortgage.

What Are Lender Credits?

Lender credits are the opposite of discount points. Instead of you paying more upfront to buy down your rate, your lender will provide you with credit toward your closing costs. In exchange for reducing your upfront cash, you’ll pay a slightly higher interest rate, which means your monthly payment will be a little higher.

If you’re short on cash but have enough income to easily pay a little more each month, you may want to discuss the option of lender credits. Sometimes when lenders refer to a “no closing cost” or “reduced closing cost” option, this means they’re offering lender credits.

Can a Seller Buy Down my Mortgage Rate?

Sellers are allowed to offer to pay part of their buyer’s closing costs during negotiations, including a seller credit that can be used to buy down your mortgage rate. When mortgage rates are relatively high, some builders and sellers offer buying down the interest rate as an incentive to buyers.

Seller and builder closing cost credits can be used to buy down the rate permanently or temporarily, such as for the first one, two or three years of the loan to generate monthly payment savings for a few years.

Understanding Temporary Buydowns

A temporary buydown reduces your interest rate for only the first one, two or three years of the loan — not for its full term. The most common structures are the 2-1 buydown (rate drops 2% the first year and 1% the second year, then returns to the note rate) and the 1-0 buydown (rate drops 1% for the first year only).

Builders and sellers might offer temporary buydowns as incentives when mortgage rates are elevated, giving buyers immediate monthly payment relief while they settle into the home. Lender requirements vary, so ask your banker which buy-down options are available on your loan program.

However, loan programs limit the amount sellers can contribute to your closing costs. If you’re financing your home with a conventional mortgage, the seller can only pay up to 3% to 9% of the home price depending on the size of your down payment.

Are Mortgage Points Worth It? The Break-Even Calculation

While borrowers who have limited cash are likely to quickly decide against paying mortgage points, for others the key question is how long you plan to stay in your home. Generally, if you plan to keep your home for the long term, it could make sense to lower your interest rate and pay discount points.

To evaluate this choice, you need to calculate your break-even point, which is when your monthly savings cover your upfront costs. To make this calculation, divide the cost of the mortgage points by your monthly savings. For example, if you paid $4,000 for one point and it saves you $66 per month on your mortgage payment, it will take about 60 months (five years) to recoup your costs.

If you stay a lot longer than your break-even period, then paying for points can generate long-term savings. For example, if you keep your home in the above example for 30 years, you will save nearly $24,000 in interest over the life of the loan.

However, if you sell, refinance or pay off the loan before your break-even point, buying points will likely cost you more than it saves.

When Buying Points Makes Sense

There are several scenarios when buying points can be a smart move. For example:

• If the seller pays your discount point with a credit, your cost is zero and you save on interest payments
• If you plan to stay in the home long enough to pass the break-even point, you’ll generate savings beyond the initial cost
• If you have cash available on top of your down payment and closing costs, it’s worth considering using some extra money to reduce your interest rate
• If your debt-to-income ratio, which compares your monthly payments on all recurring debt to your monthly gross income, is close to the maximum allowed by your lender, it may be easier to qualify if you buy down the interest rate
• If you want to lock in the lowest possible rate for a 30-year fixed mortgage for lower monthly costs, it may be worth paying points

When Buying Points May Not Be Worth It

Paying points may not be your best choice under some circumstances, such as:

• If you plan to sell or refinance within a few years, since you’re unlikely to recoup your costs
• If you need your cash reserves for the down payment, closing costs and an emergency fund
• If you have just enough to make a down payment of 20%. If you take cash for discount points and make a smaller down payment, you’re likely to be required to pay private mortgage insurance, which would probably eliminate the savings benefit
• If you’re buying in a higher-rate environment and anticipate that mortgage rates will decline, so that refinancing your mortgage later is likely.
  

How Do I Know If Points Are Available on My Loan?

When you meet with a lender to get a mortgage pre-approval and to discuss your loan options, your lender will offer mortgage points as one of those options. The Loan Estimate will list discount points and your mortgage rate.

Points are available on most loan types — conventional, FHA, VA and jumbo mortgages. However, the maximum number of points you can buy and the rate reduction per point may differ. On VA loans, for example, the lender must certify the loan is still in the veteran’s best interest after the discount points are applied. Loan-program rules also govern how much of the cost a seller or builder can contribute. Your banker can confirm what’s allowable for your specific loan program.

If you’re buying a newly built home, you can ask your builder about paying discount points to buy down your mortgage rate as part of an incentive package.

If you’re buying an existing home, you can negotiate with the seller to pay points on your behalf.

To learn more about your options, contact an RBC U.S. Mortgage loan officer at City National Bank today.