When you’re in the market to buy a home, it’s not uncommon to start crunching the numbers and trying to find ways to lower the monthly payment that you’re about to sign up to pay for many years.
You might, for example, take steps to improve your credit score so that you can qualify for a lower interest rate on your loan. Alternatively, you might also decide to save up a larger down payment: This will allow you to purchase your home with a smaller loan, which will translate into lower payments and less interest paid over the life of the loan.
Another option? You can actively purchase a lower interest rate by buying what are known as “mortgage points” from your lender.
Below, we take a look at what mortgage points are, how they work, and whether or not they make sense for homebuyers looking to reduce the cost of their mortgage.
What are mortgage points and how do they work?
Mortgage points are essentially an optional fee that you can pay a lender in exchange for a reduced interest rate on your mortgage. Mortgage points are also sometimes known as mortgage discount points or even just discount points depending on the lender.
Each point is equal to 1 percent — or one point — of your total loan amount, which is where the term comes from. If you had a $400,000 mortgage, for example, one point would cost you $4,000.
Generally speaking, each mortgage point will lower the interest rate on your loan by 0.25 percent. With this in mind, if you have a mortgage with an interest rate of 6 percent and you pay for one point, it would lower your rate to 5.75 percent; if you paid for two points, your rate would be 5.5 percent.
It’s important to remember that this is not set in stone: Lenders can decide that a point will translate into a different discount, so you need to know exactly what you are paying for before you agree to their terms.
How many mortgage points can you buy?
As a borrower, you can buy anywhere from a fraction of a point to multiple points, depending on how much cash you have on hand.
While there’s no legal maximum for how many mortgage points you can buy, most lenders will limit you to purchasing around four points because they will ultimately eat into your lender’s profit margin over the long term.
When do you pay for mortgage points?
If you’ve decided to buy mortgage points, you’ll pay for them at closing.
How mortgage points affect interest
To illustrate the effect that buying mortgage points can have on a mortgage, imagine that you have decided to purchase a home using a $400,000 mortgage. It is a 30-year fixed-rate loan carrying an interest rate of 6 percent.
If you do not purchase any mortgage points (and haven’t refinanced your mortgage), you will pay more than $463,000 in interest over the life of the loan.
Now imagine that you have decided to pay for two mortgage points, at a cost of $8,000. In this case, you will pay a little less than $418,000 in interest, a savings of about $46,000.
Seems like a no-brainer, right? Well, maybe.
Is buying mortgage points a good idea?
As shown in the example above, paying for mortgage points can lead to substantial savings over the life of your loan. But it’s important to crunch the numbers before committing yourself, because in certain scenarios paying mortgage points may end up costing you money.
For mortgage points to be worth it, it’s typically recommended that you plan to own your home at least until you reach the break-even point. This is the point at which you have recouped your initial investment (what you paid to purchase the points) in the form of interest savings, and when you will actually begin to enjoy the perks of lower rates.
To calculate the break-even point, all you need to do is divide the cost of your points by the amount of monthly savings that it translates into. For example, if you paid $4,000 for one point and it translated into a $50 per month saving, then you would divide $4,000 by $50. This means you’d need to own your home for at least 80 months (or about six and a half years) in order to justify paying for the points.
Of course, you also have to ask yourself: Is this the best way for you to put your money to work? For example, if you carry debt with a higher interest rate, would it be better for you to use that cash to pay it down? Alternatively, do you think you would enjoy a higher rate of return by investing the money?
If you are unsure whether or not buying mortgage points is the best use of your money, a financial planner can show you how all the pieces of your financial life work together and help you get a better sense of what’s best for your situation.