How Do Mortgage Points Work?

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Of all the costs of homeownership, mortgage interest is one of the largest, adding significantly to your monthly mortgage payment and increasing the amount you pay for your home by tens or hundreds of thousands of dollars over the life of your loan. But you do have some control over how much interest you pay.

Buying mortgage points can save you money on interest over time while reducing your payment or shaving years off the time it takes to repay your mortgage loan.

What Are Mortgage Points?

Mortgage points, also called discount points, are prepaid interest you pay at closing in exchange for a lower interest rate on your mortgage loan. Although points require more cash upfront, prepaying some of your interest reduces your monthly payment and can greatly reduce the total cost of your loan. That’s why purchasing mortgage points is called “buying down” your mortgage.

 How Do Mortgage Points Work?

In most cases, a mortgage point is 1% of your mortgage loan amount, and it reduces your interest rate by 0.25%. On a $200,000 loan at 4% interest, one point would cost $2,000 and reduce your interest rate to 3.75%.

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You don’t necessarily have to purchase whole points. You might pay $5,000 to buy 2.5 points on a $200,000 loan, for example, and reduce your interest rate by 0.625% to 3.375%. Although there’s no legal limit on how many points you can buy, there are limits on closing costs lenders can charge. For this reason, lenders generally cap points at 4% or less.

Good To Know

Mortgage points work the same way when you refinance your home. However, you might not recoup your prepayment unless your refinance extends the remaining term on your current loan.

Are Mortgage Points Good or Bad?

Mortgage points are good under certain conditions, but in others, it’s best to steer clear.

Why Mortgage Points Are Good

Here are some ways mortgage points can work in your favor.

Mortgage Points Can Save You Money on Interest

The best thing about mortgage points is that they reduce the cost of your loan. You can take advantage of that benefit either by reducing your mortgage payment or putting the savings toward your principal balance and paying your loan off early.

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The mortgage points calculators found on various lenders’ websites show you how that plays out in real terms. For example, a $200,000 loan with two points that reduce the interest rate from 4% to 3.5% would cost you an additional $4,000 at closing but save you $16,427 over the life of the loan, according to the calculator on the Chase website.

Mortgage Points Are Tax Deductible

When you use the mortgage loan to buy or build your primary home, and that home secures the mortgage loan, the IRS generally allows you to deduct mortgage points in the same year you pay them.

You can also deduct points on a refinance loan in the same year you pay them as long as you use the loan proceeds to improve your main home. Even on mortgage loans with points, you can’t deduct in the same year, you may deduct a rated portion each year over the life of the loan.

Why Mortgage Points Are Bad

If you’re not careful, mortgage points can work against you.

Mortgage Points Mean Paying More at Closing

It can be a stretch for a buyer to come up with extra cash for closing. If that’s true for you, buying points upfront would deplete cash reserves you could put toward a larger down payment — thereby reducing your interest by reducing your loan amount — or sock away in an emergency fund.

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It Can Take a Long Time To Break Even

Because you pay interest a little at a time over the life of your loan, it can take years before you break even on the lump sum you pay upfront for points. This might not matter if you’re planning to stay in your home until the loan is paid off. Otherwise, use an online points calculator to do the math.

Paying two points, or $4,000, to reduce interest on a $200,000 mortgage from 4.5% to 4% would cost $1.548 more over the first three years you own the home than if you’d applied that extra $4,000 to your down payment. The break-even point comes in the fifth year, and by year six you’d have saved $872. If you sell your home before you break even, the points will have cost you more than they saved you in interest.

This is an especially important consideration for borrowers planning to buy a home with an adjustable-rate mortgage because the rate discount usually only applies to the initial fixed-rate period. You might be better off with a slightly higher rate on a loan that resets after three or five years.

Are Mortgage Points Worth It?

Mortgage points are worth it if you have the extra cash and you plan to stay in your home long enough to break even. If you’re planning to sell before that or can’t spare the money, you can always make extra principal payments later to make up for the higher interest rate you’ll pay if you don’t buy points.

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About the Author

Daria Uhlig is a personal finance, real estate and travel writer and editor with over 25 years of editorial experience. Her work has been featured on The Motley Fool, MSN, AOL, Yahoo! Finance, CNBC and USA Today. Daria studied journalism at the County College of Morris and earned a degree in communications at Centenary University, both in New Jersey.
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