Introduction
Homebuyers who need to get a mortgage are usually faced with numerous options that will affect the total amount they pay for their loan. One of the factors in this equation that usually tends to confuse them is mortgage points. These details have the potential to affect your mortgage payments, the amount of interest you pay over the duration of the loan, and the total price of your home. Knowing about mortgage points and how they operate can assist in helping you make a smarter choice on your mortgage. In this article, we will discuss what mortgage points are, how they work, and if buying them really saves you money in the long run.
What Are Mortgage Points?
Mortgage points, also known as discount points, are pre-paid fees given to a lender during the closing in return for a lower interest rate on the loan. Essentially, borrowers are purchasing a lower interest rate on their loan by paying for mortgage points, which decreases their monthly mortgage payments. Each point typically costs 1% of the loan amount. So if you have a mortgage loan of three hundred thousand dollars, one point would be three thousand dollars.
It is necessary to distinguish between two categories of mortgage points: discount points and origination points. Discount points are the points which are most usually talked about with respect to reducing interest rates and monthly payments. Origination points are charges that the lender levies for processing and approving the loan. They do not affect the interest rate or monthly payment directly.
This piece is mostly about discount points since these are the ones that affect the conditions of your mortgage by reducing your interest rate.
How Do Mortgage Points Work?
The purpose of mortgage points is fairly simple. When you buy mortgage points, you are essentially paying a up-front cost to decrease your interest rate for the life of the loan. Generally, for each point you buy, you will get your interest rate lowered by about 0.25%. The more points you buy, the lower your interest rate will be. This has the effect of having lower monthly mortgage payments during the life of the loan.
But it should be noted that purchasing mortgage points comes with an initial cost. This implies that you need to have the funds available to pay for the points at the time of closing. Although paying for mortgage points can lower your monthly payments, it does come with a significant upfront cost. Borrowers need to consider very carefully if they are financially ready to pay this up-front fee and if the saving from the lower interest rate will cover the cost of the points in the long term.
For instance, assume you have a two-hundred-thousand-dollar loan with a 4.5% interest rate. If you purchase one point for two thousand dollars, your interest rate could drop to 4.25%. This will reduce your monthly payment so that you save each month. Still, whether or not you should purchase points is determined by how long you intend to remain in the home and whether the long-term savings are worth the upfront expense of the points.
The Cost of Buying Mortgage Points
As stated above, one mortgage point is usually equal to 1% of the loan. For instance, if you are financing a mortgage for two hundred thousand dollars, one point would cost you two thousand dollars. It should be noted that the price of purchasing mortgage points is a one-time payment at closing, and this is in addition to your down payment and other closing fees.
By buying points, you’re paying in advance on some of the loan’s interest. The initial payment decreases your interest rate, decreasing your payments each month and how much total interest you’ll pay on the loan. In most cases, you may buy as many as three points, but how many points you can buy is up to the lender and the loan program under which you’re applying.
Though the price of mortgage points is a simple cost, it must be weighed with caution. You must decide if the lower monthly payment will be worth the initial investment in points. That is, the question arises: Does the expense of the points exceed the long-term gain?
Will Buying Points Save You Money?
One of the most frequently asked questions by homebuyers is whether purchasing mortgage points will ultimately save them money. The response is not a straightforward yes or no; it is based on a number of factors, such as how long you intend to remain in your home, the price of the points, and the decrease in your interest rate.
The trick to knowing whether buying points is a sound money decision is to determine the break-even point. That is the time when the total you save from your reduced monthly payments equals the cost of the points upfront. After you’ve gone past the break-even point, the money you save on your mortgage payments will be more than the points cost, and you are saving money.
For instance, suppose you are buying a house with a two hundred thousand-dollar loan. The interest rate is 4.5%, and you want to buy one point for two thousand dollars, lowering your interest rate to 4.25%. Your lowering of your monthly payment may be about thirty-six dollars. In order to determine your break-even point, take the cost of the point and divide it by the monthly savings. Here, two thousand dollars divided by thirty-six dollars is about fifty-six months, or roughly four and a half years.
If you will be staying in your house longer than four and a half years, then it would be more cost-effective for you to buy the point. But if you will be leaving or refinancing the house prior to reaching the break-even point, you won’t be able to recoup the cost of the points, so it might not be as beneficial for you to buy them.
When Should You Buy Points?
Whether or not to purchase mortgage points is an individual financial decision that will depend on your situation, how long you will be living in the home, and what you want from your mortgage. Here are a couple of situations in which purchasing points might make sense:
- Long-Term Homeownership: In case you keep the home for a long time, purchasing mortgage points is worthwhile. The more years you plan to reside in the property, the more money you will save over the loan’s term. For those homeowners who intend to remain in their homes, the initial expense of acquiring points can be balanced by the cost savings over the long term from the lower interest rate.
- Low Initial Out-of-Pocket Cost: If you can afford to pay for the points out of pocket and not hurt your financial situation, it can be a good idea to decrease your interest rate. Particularly, if you want smaller monthly payments and have the financial situation to make the initial investment.
- Desire for Lower Monthly Payments: If your goal is to reduce your monthly mortgage payment, buying mortgage points is one way to achieve that. By lowering your interest rate, you can reduce your monthly payment, which can improve your budget and cash flow.
However, there are scenarios where buying points may not be the best choice:
- Short-Term Homeownership: If you intend to sell or refinance the home within a few years, purchasing points is not a wise choice. Here, you might not get sufficient time to recover the initial cost of the points before you move or refinance.
- Limited Cash Flow: If paying for points would only leave you with limited savings or put a financial strain, it might be wiser to skip buying points. Instead, you could utilize your money towards some other financial goal or to pay off your higher-interest debts.
- Minimal Interest Rate Reduction: In some cases, the reduction in your interest rate may not be significant enough to justify the cost of the points. If the monthly savings are minimal, it may not be worth spending the extra money upfront.
Alternatives to Buying Mortgage Points
If you’re unsure whether buying mortgage points is the best option, there are alternative strategies you can consider to lower your interest rate or reduce your mortgage payments:
- No-Point Loan: Most lenders provide no-point loans, which is to say you don’t pay upfront fees to reduce your interest rate. The lender will probably give you a higher interest rate in return. Although this will make your monthly payments more expensive, you won’t need to make an upfront payment for points, which could be a good thing if you don’t have the extra money.
- Shop Around for the Best Rate: If buying points is not attractive, shop around for various lenders. Shopping around for loan offers from various lenders can assist you in obtaining the best interest rate without having to purchase points. Some lenders might provide a lower interest rate with no points, particularly if you have a good credit score.
- Put Down a Bigger Down Payment: Putting down a bigger down payment can sometimes enable you to get a lower interest rate. This is because the lender might perceive borrowers who have more equity in the house as less risky. By paying more money down initially, you may be able to skip buying points and still get a good interest rate.
Conclusion
Mortgage points are a useful tool for homebuyers wanting to decrease their monthly mortgage payments and decrease the amount of interest paid over the course of the loan. Buying points is not always the optimal decision for all borrowers, though. Whether buying mortgage points is a good move is based on considerations like how long you are going to be in the home, the expense of the points, and how much your interest rate will decrease. Before making a choice, it’s essential to compute the break-even point and see if the initial investment of the points is worth it in terms of long-term savings. If you expect to live in the house for a long time and can pay the points upfront, purchasing points can be a financially savvy strategy. If not, you can explore other mortgages or interest rate reduction strategies that don’t involve paying points.
