Paying extra fees on a loan may sound counterintuitive, but when it comes to a mortgage, paying for points upfront can be a smart financial move. Understanding how points work is key to getting the best deal on your home loan.
Discount Points vs. Origination Points
When a lender mentions “points,” they could be referring to one of two types. It’s crucial to ask for clarification.
- Discount Points: These are what borrowers typically mean by “mortgage points.” They represent prepaid interest and are an optional fee you pay to get a lower interest rate on your loan.
- Origination Points: These are fees a lender charges for processing and underwriting your loan application. An origination fee is essentially a commission. While it’s also calculated as a percentage of the loan amount, it does not lower your interest rate.
How Mortgage Points Can Lower Your Payments
The general rule is that one discount point, which costs 1% of the total loan amount, reduces your interest rate by approximately 0.25%. This can vary by lender and market conditions, so always confirm the exact reduction.
Let’s use a hypothetical $400,000, 30-year fixed-rate mortgage to illustrate.
| Scenario | Without Points | With 1 Point |
|---|---|---|
| Loan Amount | $400,000 | $400,000 |
| Interest Rate | 7.0% | 6.75% |
| Upfront Cost of Points | $0 | $4,000 |
| Monthly Payment (Principal & Interest) | $2,661 | $2,594 |
| Monthly Savings | $67 |
In this example, paying $4,000 at closing saves you $67 per month. To determine if this is worthwhile, you need to calculate your break-even point.
Calculating Your Break-Even Point
The break-even point is the time it takes for your monthly savings to cover the initial cost of the points.
The formula is: Cost of Points ÷ Monthly Savings = Months to Break Even
Using our example: $4,000 ÷ $67 = 59.7 months (or about 5 years)
If you plan to stay in the home for longer than five years, you will save money over the life of the loan. However, if you sell the home or refinance before reaching the break-even point, you would lose money on the transaction.
What Are Negative Points or Lender Credits?
If you need help covering your closing costs, you can ask your lender about negative points, also known as lender credits. In this scenario, the lender agrees to cover a portion of your closing costs, but in exchange, you accept a higher interest rate. This increases your monthly payment but reduces the cash needed to close, making it a useful option for some homebuyers.
Are Mortgage Points Tax Deductible?
Yes, the IRS allows homeowners to deduct discount points as prepaid mortgage interest. According to IRS Publication 936, you can typically deduct the points in the year they were paid if you itemize deductions and meet several other criteria. Because tax laws can be complex, it’s always best to consult with a qualified tax professional about your specific situation.
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