Mortgage Q&A: “Are mortgage points worth it?”
When taking out a mortgage, whether for a new purchase or to refinance an existing loan, one decision you’ll undoubtedly have to make is if it’s worth paying mortgage points to obtain a certain interest rate.
Before we get into that, it’s important to note that the term “points” gets thrown around loosely, and can refer to the loan origination fee and/or discount points.
It’s an important distinction because the loan origination charge is basically unavoidable (they need to eat, right?), while paying discount points (prepaid interest) is entirely optional depending on the rate you desire.
Do You Want an Even Lower Mortgage Rate?
- You can obtain an even lower mortgage rate
- If you elect to pay points at closing
- They are a form of prepaid interest
- That reduce your interest expense on the loan
Let’s assume you’re shopping for a $100,000 mortgage.
While mortgage rate shopping, you’ll probably pay the most attention to the big, glaring rate in front of you, such as 2.99%.
But if you look under that rate, or in the small, fine print, you should see more details about the rate, such as the fact that it requires you to pay two mortgage points.
In this case, those two points are mortgage discount points, which lower the rate to that amazingly low 2.99% you see advertised.
But those two points will cost you $2,000, using our $100,000 loan example, as each point is equal to one percent of the loan amount.
If you don’t want to pay those two points, your actual mortgage rate will probably be markedly higher, perhaps 3.5% instead.
And the bank or lender may inform you that you have to pay “points” to get that low, advertised interest rate on your mortgage.
It’s kind of like a car lease where you’re told payments are only $199 per month for 36 months, but it requires $2,500 cash at signing. Is it really just $199?
If you want to accurately gauge the deal, you need to consider that upfront cost. In the case of the car lease, it’s another $69 per month, or about $268 per month once factored in.
Your buddy might have scored the same monthly payment with nothing down, so it’s not really apples-to-apples.
The same goes for mortgages – how much are you paying to get the rate you want or brag about?
Anyway, back to our mortgage example, when looking at difference in payment, we’d be talking about $27 per month if you opted for the lower 2.99% rate while paying two points.
Tip: Keep in mind that the discount points are paid in addition to any lender fees charged for origination, processing, underwriting, and so forth.
When You Break Even Determines If Points Are Worth It
- The break-even point
- Is when you recoup the cost of the points
- Thanks to lower monthly mortgage payments
- As a result of the lower interest rate
While 2.99% certainly sounds a heck of a lot better than 3.5%, it’s actually only a $27 difference when you make your mortgage payment each month.
Not as awesome as it looked, eh. And guess what? You just paid $2,000 upfront, out-of-pocket for that $27 monthly discount.
And money spent today is more expensive than the same money spent in the future thanks to our friend inflation.
It’s also long gone the minute you spend it, trapped in your home at a time when money may be tight thanks to other closing costs and housing-related expenditures.
So why would someone want to drop a couple thousand bucks for a tiny payment reduction? Well, assuming they stick with the loan long-term, the savings will come. It’ll just take a while…
The month at which you start saving money and essentially make those points worth the upfront cost is called your “break-even point.”
Factor in Tax Bracket and Savings Rates
- To properly determine the break-even point of paying points
- You need to take into account your tax bracket
- And figure out the actual savings assuming you itemize
- While also looking at current savings account yields
The proper break-even point factors in your income tax bracket and current savings rates, not just the difference in monthly payment. It also accounts for faster principal repayment.
Of course, if you invest the money in stocks or bonds or whatever else, it could shift the break-even point tremendously.
If you want a good idea of when you’ll hit this magical point, look for a break-even calculator online that takes into account all the important details.
In our example, with a tax bracket of 25% and a current savings account yield of 1%, it would take roughly 51 months to break even, or for paying mortgage points to be worth it (make sense financially).
Put simply, if you don’t plan on spending at least four years in your home, or more importantly, with the mortgage, it’s not worth paying the points.
However, if you’re the type that wants to pay as little interest as possible over the life of your loan because you’re in it for the long-haul, paying mortgage points can be a smart move.
In fact, if you see the mortgage out to its full term, you’d pay roughly $10,000 less in interest versus the higher rate mortgage. That’s where you “win.”
In summary, there’s probably a lot of wastage when it comes to paying mortgage points because people don’t actually do the math, they just get excited about a certain interest rate. Then they refinance or move before seeing any savings.
But if you’re planning to hunker down for a while, now is a great time to pay points, seeing that rates are at all-time lows.
That makes the prospect of a refinance unlikely, unless you need to tap equity in the future. The only drawback is if you sell your home before realizing the benefit.
Just be sure you actually secure a lower interest rate when paying points. Those who don’t shop around could wind up with a higher rate compared to those who avoided paying points altogether. In other words, shop both rates and points!
Situations Where Paying Mortgage Points Can Be Worth the Cost
- While rates are low (less likely to refinance because it won’t get much better)
- If it’s your forever home (can be free and clear for less money)
- If you have a retirement goal to pay off the mortgage (as opposed to sell/refi it)
- On a property you occupy now but will rent out (can lock-in a low rate now)
- If deducting them from taxes can help you in a given year
Benefits of Buying Mortgage Points
- You get a lower interest rate
- Your monthly payment will be smaller
- You’ll pay less interest over time
- You’ll build equity faster
- Points are generally tax deductible
- You can brag to friends about your low rate
Disadvantages of Buying Mortgage Points
- You have to pay a large upfront cost for a lower interest rate
- The monthly savings may be negligible
- It could take a long time to break even
- You’ll lose money if you sell/refinance before breaking even
- You’ll have less cash on hand for other expenses
- Money may earn a better return elsewhere
- Smaller mortgage interest deduction
Read more: Are mortgage points tax deductible?