What are mortgage points, and how do they work?
Mortgage points are fees a homebuyer can pay upfront in exchange for a lower interest rate. It’s important to understand the effect of paying points on the long-term cost of a mortgage.
How does it work?
Lenders will offer you the option to pay points along with your closing costs. In exchange for each point you pay at closing, your mortgage interest rate will be reduced, and monthly payments will reduce as well.
Each point equals 1% of the amount borrowed and is usually paid in cash at the time the loan is closed. Example: on a $100,000 loan, one point would be $1,000.
Home buyers must often choose between a higher mortgage rate with no points or a lower mortgage rate with one, two, or more points. To determine which is more cost-effective for you, calculate how much additional interest must be paid over the life of the loan in order to pay less money upfront. A general rule is to equate each point with one-quarter percent interest rate. Thus, an 8.75% loan with two points costs approximately the same as a 9% loan with one point.
However, the rule is only accurate for the first several years of the loan. The longer you plan to keep your home, the less effect points will have on the annual mortgage rate. In general, if you are buying a permanent home that you intend to own for five to seven years or more, you may wish to pay the higher points and take the lower rate. If you are contemplating a shorter length of residence, you may wish to consider paying the lower points or no points and take the higher rate.
Advantages
- If your credit score is low, you’ll likely pay a higher interest rate on your loan. Purchasing points can help you get a lower rate on your mortgage regardless of your credit score.
- A lower interest rate means a smaller mortgage payment. If you’re having trouble qualifying for a mortgage because of low income, purchasing points to achieve a lower interest rate and mortgage payment may help.
- You may also save money over the life of the loan by locking in a lower interest rate.
Disadvantages
- With each monthly payment, the savings from your lower interest rate will add up over time. But if you move or refinance too soon, you may not recoup the cost of your points.
- Also, depending on your financial situation, mortgage points might not be the best investment for available funds. Lowering your mortgage interest rate may not bring the same rewards as other investments.
Taxes must also be considered in any borrowing situation. While points for home purchase mortgages are typically fully deductible for the year in which they are paid, points on refinanced mortgages must be prorated over the life of the loan. It’s important to evaluate your circumstances to minimize your cost and determine what effect paying points will have on your situation. The more knowledge you have, the more you may find yourself “home free.”