Mortgage Q&A: “Are mortgage points worth it?”
When taking out a mortgage, whether for a new home 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 an even lower interest rate.
Jump to paying mortgage points topics:
– Do You Want an Even Lower Mortgage Rate? Pay Points!
– When You Break Even Determines If Points Are Worth It
– Factor in Your Tax Bracket and Savings Rates
– Situations Where Paying Mortgage Points Can Be Worth the Cost
– Benefits of Buying Mortgage Points
– Disadvantages of Buying Mortgage Points
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.
The loan origination fee is the commission charged by the bank or loan officer in exchange for working on your loan, whereas discount points are optional costs used to buy down your interest rate.
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.
Note that not all lenders charge loan origination fees, but that could just mean the cost is already baked into the interest rate.
Either way, take the time to compare lenders’ rates and fees to ensure you get the best combination of both.
Do You Want an Even Lower Mortgage Rate? Pay Points!
- 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
- Instead of paying more each month, you pay more upfront
- This will save you money over the life of the loan via reduced interest
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!
[Watch out for rates you have to pay for!]
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 we’re talking about a larger loan amount, such as $500,000, it’s all of a sudden $10,000. Ouch!
Assuming 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
- When paying points you need to consider the break-even point
- It’s the time period in which you recoup the upfront cost of the points
- How long it takes will depend on the rate benefit and price paid
- Be sure to consider how long you plan on staying in the home/mortgage while making the decision
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 home 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 Calculate Break-Even Point
- To properly determine the break-even point of paying mortgage points
- You need to take into account your individual tax bracket
- This way you can figure out the actual savings assuming you itemize your taxes
- You also need to look at savings account yields or what your money would earn elsewhere
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 those 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).
Simply put, 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 who 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 below some important psychological threshold and go with that. Then they refinance their mortgage or move before seeing any savings.
But if you’re planning to hunker down for a while, now could be a great time to pay points, seeing that rates are at all-time lows and likely won’t move much lower.
Of course, we all thought mortgage rates had bottomed out last year, and the year before that.
Meaning a lot of homeowners who had no intention of refinancing probably did so again. And they may have lost out on those points in the process.
Still, with rates already so low and the big gains harder to come by, it makes the prospect of a refinance unlikely, unless you need to tap equity in the future.
The only real drawback is if you sell your home before realizing the benefit.
Lastly, 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! It’s possible to get a good deal on both if you put in the time and effort.
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 eventually for a lot 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 in the future (can lock-in a low rate now)
- If deducting points from taxes can save you money 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
- Money loses value over time due to inflation
Read more: Are mortgage points tax deductible?