How Mortgage Points Work And When To Buy Them
The current market is historically difficult for first-time home buyers. Housing inventory has reached an all-time low last year and federal interest rates are currently at their highest since 2007. In fact, according to U.S. News, two-thirds of Americans who plan to buy a home this year want to wait until mortgage rates lower before they enter the market. All this may seem dire, but there are options.
For those looking to lower monthly mortgage payments despite high interest rates, there is the option to buy mortgage points, or “discount points.”
What Are Mortgage Points And How Do They Work?
Mortgage points are fees that a borrower pays a lender upfront to lower the interest rate on the loan for the entire term. Essentially, they represent a form of prepaid interest. Each point costs 1 percent of the mortgage amount. And typically, purchasing 1 point will lower the interest rate by 0.25 percent. For example, 1 point on a $400,000 mortgage would cost $4,000. If the mortgage rate was 6.5 percent, the purchase of one point would lower the rate to 6.25 percent for the life of the loan.
Borrowers can purchase anywhere from fractions of a point up to multiple points. And while 1 point typically lowers the interest rate by 0.25 percent, this ultimately depends on the lender, the type of loan, and the interest rate environment. The lender will go over all of this information with the potential buyer and explain how the numbers work for their mortgage lending system.
The points purchased are paid at closing. According to Bankrate, points purchased will be listed on the loan estimate document the buyer receives after they apply for a mortgage as well as on the closing disclosure, which they will receive before the loan closes.
When Does It Make Sense To Purchase Mortgage Points?
Purchasing mortgage points can be a great investment in a few cases.
- The buyers plan to stay in the home for an extended period of time
- The buyers don’t plan on refinancing
- The buyers can make a down payment of 30 percent
Because these points ultimately pay off over time, the buyer will want to make sure that they plan on living in the home long enough to recover their costs. You can help them figure out how long that might be by dividing the cost of the points by the amount that would be saved each month. The total will be the amount of months it would take to recover the cost. If a client plans on staying in the home longer than this, the savings could be worth it.
With interest rates being a main cause of concern with potential buyers right now, many people planning on purchasing a home hope to refinance when interest rates lower. If refinancing is in a buyer’s future refinance, purchasing mortgage points wouldn’t make sense as the deal would go away with the mortgage. Advise them to consider the timeline and potential for refinancing before investing in points.
Depending on the type of loan a buyer is taking out, they might only want to purchase mortgage points if they’ve made at least a 20 percent down payment. With a down payment of at least 20 percent on a conventional loan, the buyer will avoid private mortgage insurance (PMI) and get the best interest rate offered by the lender. If they put down less than 20 percent, the interest rate will be higher because the loan-to-value ratio (the mortgage compared to the home’s cost) is wider. Investing more into a down payment could lower the interest at a larger rate than purchasing mortgage points would. This differs from FHA loans and VA loans, which require different types of mortgage insurance or no insurance at all. Examining the type of loan along and annual percentage rate (APR) will help the buyer make the right decision.
To illustrate the idea, the following figure shows the potential savings over a 30-year loan on a $400,000 fixed-rate mortgage with a 20 percent down payment.
The right column shows savings for 2 mortgage points purchased. To save the full amount of $37,559, the buyer would have to stay in the home for the full 30 years and never refinance.
Using the calculation we discussed earlier, you can see how many months it would take for this buyer to at least break even on their point purchase. In this case, $104 is saved each month after purchasing 2 points for $6,400, so the formula looks like this:
$6,400/$104 = 61.5 months
This means in just over five years they would recover the cost of the purchased points and begin to see long-term savings.
While monthly payments might be the most worrisome part of purchasing a home in today’s market, it’s reassuring to know there are options that could help buyers save money in certain situations. As always, we advise talking to the client and their lender and to help them decide what’s the best approach.