What Are Mortgage Points and When Should I Buy One?
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Reader question: "I was told I could get a lower interest rate on a home loan if I paid points at closing. I'm not very clear on the relationship between these two things. What is a mortgage point, and when does it make sense to use them when buying a home?"
Mortgage points are a form of prepaid interest. Basically, you're paying additional money up front to secure a lower interest rate on the loan. This strategy could save you a lot of money, if you keep the loan long enough. Thus, it's a strategy best reserved for a long-term stay. If you're only going to be in the house for a few years (as with a temporary relocation), it probably won't make sense to pay points.
That's the short answer. Now let's take a closer look at mortgage points, and when it makes sense to use them.
What is a Mortgage Point?
Definition: A mortgage point (also known as a discount point) is a type of prepaid interest on a home loan. One point is equal to one percent of the loan amount. With a $250,000 loan, one point would equal $2,500.
Lenders will generally reduce the interest rate by one-eighth of a percent (0.125 percent) for every point paid, though the exact amount may vary. So if you started with an interest rate of 6.5 percent, and you paid a mortgage point to reduce it, you could end up with a revised rate of 6.375 percent.
As a borrower, you must know exactly how much your rate will be reduced for paying mortgage points. This is the only way to calculate your savings over time. So, by extension, it's the only way to decide if this strategy makes sense in the first place.
The Benefit of Paying Points
Under the right circumstances, the paying of points can benefit the lender as well as the borrower. Here's how:
- The lender gets a higher yield on the loan, because the borrower is paying more than the stated interest rate. So it increases the lender's upfront profit.
- The borrower can save money over the life of the loan, by securing a lower interest rate. In order to achieve this, however, the borrower must keep the loan for a certain period of time. We will talk more about this "break-even point" below.
The lender's benefits are in the short term, while the borrower can benefit over a period of years.
When Does It Make Sense to Pay Them?
Many home buyers choose to pay mortgage points at closing. The goal here is to reduce the interest rate over the term of the loan. But when does it make financial sense to do this?
Here's the rule of thumb. At some point during the payback period, you will reach the break-even point. This is where the money you save (with the reduced interest payments) begins to exceed the amount you paid to buy down the rate.
Tip: The break-even point is when your total savings exceed the cost of paying for mortgage points at closing. If you sell or refinance the home before reaching this point, you'll have a net loss instead of a gain. So you need to think about your long-term plans before making a decision.
This will be much easier to understand once we plug in some numbers...
How to Determine the Break-Even Point
Does it make sense to pay mortgage points at closing? To answer this question, you need to know two things: (1) your loan amount, and (2) the time when your savings begin to exceed your costs. Remember, a point equals one percent of the loan amount. That's the first piece of information you need. Next, you need to determine your break-even point. You need to now how many months you'll need to keep the loan to justify the cost of the mortgage points.
Here's how to do it:
- Find out what your monthly payment will be without using points.
- Determine your reduced payment when paying points at closing.
- Determine your monthly savings by subtracting the lower payment from the higher.
- Divide (A) the amount of money the lender will charge for points by (B) the amount you save each month. The number you get from this calculation shows you how many months it will take to reach the "break even" stage.
Let's say I take out a 30-year fixed-rate mortgage in the amount of $200,000.
- With no points and a 7-percent interest rate, monthly payment = $1,330.60.
- If I pay one point at closing ($2,000), my reduced payment = $1,313.86.
- I subtract the lower number from the higher number to determine my monthly savings. Based on these numbers, I would save about $16.74 per month. That's not a very big savings. So you can already see that it will take some time to recoup my $2,000 expense.
- Next, I would divide the cost of paying the point ($2,000) by the monthly savings. 2,000 divided by 16.74 = 119.
Now I've determined my break-even point. It's 119 months, or about ten years. In order to recoup the $2,000 expense of paying the point at closing, I would have to keep the loan for about ten years. This is just to break even, mind you. In order to truly benefit from this strategy, I would need to keep the loan beyond the break-even date -- the longer the better.
Summary and Conclusion
Mortgage points are a form of prepaid interest. One point equals one percent of the loan amount. By paying this amount at closing, you could secure a lower interest rate on your loan. But the rate reduction alone does not justify using the strategy. You will need to keep the mortgage for a certain period of time to recoup your expense. Thus, paying points might make sense if you plan on living in the home for more than a few years.
Of course, this adds to your overall closing costs. So you should get an estimate of those costs before making a decision about points.
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