Mortgage points

What Is Mortgage Points?

Mortgage points, also known as discount points, are upfront fees paid to a lender at the time of closing a real estate loan in exchange for a lower interest rate on the mortgage. These points fall under the broader category of real estate finance, specifically within the realm of closing costs associated with a home loan. Each point typically costs 1% of the total loan amount. By paying mortgage points, borrowers essentially prepay a portion of the interest, which can lead to reduced monthly payments over the life of the loan. This strategic financial decision involves an initial outlay of capital that aims to provide long-term savings by reducing the overall cost of borrowing the principal amount.

History and Origin

The concept of mortgage points evolved as a mechanism within the mortgage industry to adjust the yield on a loan, which functions similarly to a bond. As the market for home loans matured, particularly with the rise of a robust secondary mortgage market involving entities like Fannie Mae and Freddie Mac, lenders sought flexible ways to price their offerings and manage risk. Rather than a singular invention, mortgage points became a common financial tool, allowing lenders to offer varied interest rate options while maintaining profitability. The Federal Reserve Economic Data (FRED) has historically tracked data related to origination fees and discount points, reflecting their ongoing presence in the U.S. mortgage landscape as a quantifiable component of home financing². This flexibility allows borrowers to "buy down" their interest rate, a practice that has become a standard offering in the homeownership process.

Key Takeaways

• Mortgage points are upfront fees paid to a lender to secure a lower interest rate on a mortgage.
• Each point typically costs 1% of the total loan amount.
• Paying mortgage points can lead to lower monthly mortgage payments and potentially significant savings over the loan's lifetime.
• The decision to pay points often involves calculating a break-even point, which is the time it takes for the monthly savings to offset the initial cost.
• Mortgage points are generally considered prepaid interest and may be eligible for a tax deduction under certain conditions.

Formula and Calculation

The calculation of mortgage points is straightforward:

Where:

• Cost of Points is the dollar amount paid for the mortgage points.
• Loan Amount is the total principal amount of the mortgage.
• Number of Points is the percentage expressed as a whole number (e.g., 1 for 1%, 2.5 for 2.5%).

For example, if a borrower secures a $300,000 loan and opts to pay 1.5 points, the calculation would be:

Cost of Points = $300,000 \times (1.5 / 100) = $300,000 \times 0.015 = $4,500

This $4,500 would be added to the closing costs.

Interpreting the Mortgage Points

Interpreting mortgage points involves understanding their trade-off: paying more upfront to save money over time. The primary interpretation revolves around the "break-even point" – the duration it takes for the monthly savings from a reduced interest rate to equal the initial cost of the mortgage points. For example, if paying two points costs $6,000 and reduces your monthly payment by $100, your break-even point is 60 months (5 years).

A borrower's interpretation of whether to pay mortgage points heavily depends on their anticipated loan tenure. If a borrower plans to keep the mortgage for a period longer than the break-even point, paying points is generally financially advantageous as they will realize net savings. Conversely, if they anticipate refinancing or selling the home before the break-even point, paying points might result in a net loss. This decision requires careful financial planning and an assessment of personal circumstances.

Hypothetical Example

Consider Sarah, who is taking out a $400,000 mortgage.
Lender A offers an interest rate of 6.5% with zero points.
Lender B offers an interest rate of 6.25% with 1 point.

1. Calculate the cost of points for Lender B:
   1 point on a $400,000 loan = $400,000 \times 0.01 = $4,000.
   Sarah would pay an additional $4,000 in closing costs with Lender B.

2. Calculate monthly payments (hypothetical, for illustration):

   • Lender A (6.5% interest, no points): Monthly payment (Principal & Interest) approx. $2,528.24
   • Lender B (6.25% interest, 1 point): Monthly payment (Principal & Interest) approx. $2,462.11

3. Determine monthly savings with points:
   $2,528.24 (Lender A) - $2,462.11 (Lender B) = $66.13 per month saved.

4. Calculate the break-even point:
   Cost of points / Monthly savings = $4,000 / $66.13 \approx 60.49 months.
   This means Sarah would recoup the $4,000 paid for points in roughly 60.5 months, or just over 5 years. If Sarah expects to keep the mortgage for longer than 5 years, paying the point is financially beneficial.

Practical Applications

Mortgage points are a common feature in real estate transactions, allowing borrowers to adjust their upfront costs against their long-term interest rate. They appear prominently on the Loan Estimate and Closing Disclosure documents, which detail all associated closing costs.

• Rate Reduction: The most direct application is "buying down" the interest rate. By paying points, borrowers can secure a lower rate, leading to reduced monthly principal and interest payments over the loan term.
• Affordability Qualification: In some cases, a borrower might use points to lower their monthly payment just enough to qualify for a desired mortgage, especially if their debt-to-income ratio is borderline.
• Tax Implications: Mortgage points paid on a loan used to buy or build a principal residence are generally deductible as prepaid interest, subject to certain conditions and limitations outlined by the Internal Revenue Service (IRS) in IRS Publication 936.
• Refinancing Strategy: When refinancing a mortgage, borrowers often consider paying points to lower the new interest rate, especially if they plan to remain in the home for a significant period after the refinance.

Recent trends indicate that as market interest rates rise, more borrowers opt to pay discount points to achieve a lower rate. This strategy has become particularly prevalent among those seeking cash-out refinances, possibly because they have a ready source of liquidity to cover the upfront costs. ¹Freddie Mac provides further insights into the considerations for borrowers deciding whether to pay discount points.

Limitations and Criticisms

While mortgage points offer a way to reduce long-term interest rate costs, they come with limitations and potential drawbacks. The primary criticism centers on the concept of the break-even point. If a borrower refinances or sells their home before reaching this point, the upfront cost of the mortgage points effectively becomes a sunk cost, leading to a financial loss. This is a significant consideration, especially given the average duration many homeowners stay in their homes.

Another limitation is the immediate impact on closing costs. Paying mortgage points increases the amount of cash required at closing, which can be a barrier for borrowers with limited liquidity, even if the long-term savings are attractive. Furthermore, the exact reduction in the interest rate for each point paid can vary between lenders and market conditions, meaning a "point" does not have a fixed value in terms of rate reduction. Borrowers should also be wary of situations where lenders might include points in initial quotes to make rates appear more competitive without clear transparency about the associated upfront cost. It is crucial for borrowers to clearly understand their loan terms and all fees, not just the quoted interest rate. Borrowers with lower credit scores might also find themselves in a position where paying points is presented as a way to access better rates, potentially masking underlying risk assessments by the lender.

Mortgage points vs. Origination fees

Mortgage points and origination fees are both charges paid at closing, and while they can appear similar, they serve different purposes. Mortgage points (or discount points) are explicitly paid to reduce the stated interest rate on a loan. They are a form of prepaid interest. In contrast, origination fees are charges by the lender for processing the loan application, underwriting the loan, and other administrative tasks involved in creating the mortgage. These fees compensate the lender for their services and do not directly reduce the interest rate. While both are part of the total closing costs, mortgage points offer a direct trade-off for a lower rate, whereas origination fees are a cost of doing business with the lender.

FAQs

Q: Are mortgage points always worth paying?
A: Not always. Whether mortgage points are worth paying depends on how long you plan to keep your mortgage and the specific terms offered by your lender. You should calculate the "break-even point" – how long it takes for the monthly savings from a lower interest rate to equal the upfront cost of the points. If you expect to move or refinance before that point, paying points may not be beneficial.

Q: Can I finance mortgage points into my loan?
A: Generally, no. Mortgage points are typically paid at closing as part of your closing costs. While the cash to pay for them may come from various sources (including gift funds or seller contributions), they are an upfront cost, not added to the principal of the loan itself.

Q: Are mortgage points tax deductible?
A: Yes, in many cases. Mortgage points paid on a loan used to buy or build your main home can generally be deducted in the year they are paid. For refinancing or second homes, they are typically deducted over the life of the loan. It's essential to consult IRS Publication 936 or a tax professional for specific guidance on your situation.

Q: Do all lenders offer mortgage points?
A: Most lenders offer the option to pay mortgage points (discount points) to reduce the interest rate. However, the specific amount of points, the cost per point, and the corresponding rate reduction can vary significantly between different lenders and loan products. It's advisable to compare offers from multiple lenders.