Question: We’re looking at ads for mortgage rates. So high! What, exactly, are the “points” that some mortgage companies offer?
Answer: Points, also called discount points, are a way for the borrower to prepay some of the interest on a loan right away.
Mortgage points are essentially a form of prepaid interest you can choose to pay up front in exchange for a lower interest rate and lower monthly payments. This is often called “buying down” your interest rate.
A point is equal to 1% of the mortgage loan. If you pay that at the time that you close on your house, it will knock a little off your interest rate, typically about one-quarter percent. (Note that the reduction varies from lender to lender.)
For example, let’s say you need to borrow $500,000 to buy your new house and the mortgage rate is 7.5%. That means you would be paying $3,496 per month for (typically) 30 years. If you opt to pay for one point up front, that $5,000 will be added to your closing costs, and your interest rate will be reduced to 7.25%. Your reduced payment will be $3,411 per month. That’s a savings of $85 per month, or $1,020 per year.
Are points a good deal? There are several factors you should consider.
- Points are expensive. You probably are already making a large down payment, plus closing costs. You may have repairs to make on the property right away. Do you want to add several thousands of dollars to that? Buying points increases the amount you will hand over at the closing table.
- How much, exactly, will the rate come down? As noted above, the interest-rate reduction varies from lender to lender, but a quarter of a percentage point is typical.
- Buying points does not affect the principal amount of your loan. Points merely offset interest.
- Points will lower your long-term interest rate a bit, and you will pay less money over the life of the loan. But it will take time to recoup the cost. Hopefully you will stay in your new house long enough so that the savings on each monthly payment accumulates and eventually offsets the points pre-payment. If you’re planning to be in your new house for just a couple of years, buying the points is probably not worth the upfront investment.
- Points are pre-paid interest and may be deductible as home mortgage interest. Contact your tax specialist to discuss.
