When You Should and Shouldn’t Purchase Mortgage Points
When buying a home, there seems to be a ton of jargon to sort through and an endless sea of decisions to make, especially if you’re wanting to finance the purchase with a loan. Depending on your situation, lenders and real estate agents may suggest buying discount points during the homebuying process. But, what is a “point,” and what does it mean to buy one? If you aren’t sure, you’re not alone. While they’re not a solution for every financing scenario, understanding mortgage points may actually save you thousands of dollars over the life of a loan!
What Are Mortgage Points?
Mortgage points, sometimes also referred to as “discount points” are fees you pay to your lender in exchange for a lower mortgage interest rate. Essentially, you’re paying more upfront to pay less over time.
While the name uses the term “points,” it’s easier to think of mortgage points as “discount percentages.” The Consumer Financial Protection Bureau explains that each point equals one percent of your loan amount. For example, if your loan amount is $200,000, then one point would equal $2,000, two points would be $4,000, etc. Typically, purchasing a point will lower your interest rate by a quarter of a percent; so, if your $200,000 loan is approved at a 4.5% rate, paying $2,000 upfront could lower your interest rate to 4.25%. Most lenders will also allow you to purchase fractions of points if you desire.
It’s important to note that mortgage points are paid in addition to closing costs and are out-of-pocket expenses for the buyer.
When Should You Purchase Mortgage Points?
While not every buyer can (or should) purchase mortgage points, they are a great solution for many buyers depending on what future plans are. Buyers who intend to stay with the initial loan long term (i.e., won’t be refinancing or selling) could benefit greatly from purchasing them, because they will remain in the loan long enough to recoup the upfront costs of purchasing those points, and save money over the life of their loan.
For example, in the current market, it’s expected that mortgage rates will start to rise by year’s end, and may continue to rise for quite some time. In this case, most homeowners won’t opt to refinance (after all, who wants to refinance into a higher interest rate?), which makes getting the best rate on a loan now and sticking with it long term the more ideal scenario.
When Should You Avoid Purchasing Mortgage Points?
Having a lower interest rate sounds appealing, but purchasing mortgage points may not be the best course of action for everyone. Depending on your loan and unique situation, it could be years before you recoup the costs of purchasing loan points. In fact, depending on the amount of mortgage points purchased, it could take the entire life of the loan to break even on the out-of-pocket expense of the discount points. Plus, if mortgage rates fall and you decide to refinance, any money paid for points on the original loan would become a wasted expense.
The Mortgage Reports cautions, “Paying a fee to lower your mortgage rates might make sense over a 5- or 10- or 30-year time window. But, if you plan to move within a few years; or refinance your loan, you’ll likely never recoup your initial investment.”
In short, if you only plan to live in the home for a few years, buying mortgage points won’t be a worthy expense because you won’t be in the loan long enough to reap the benefits. A better alternative could be to use those funds for a higher down payment.
What About Other Mortgage Costs?
Another consideration: lenders require private mortgage insurance (PMI) if the down payment is less than 20% of the purchase price. PMI expenses vary from lender to lender, but tend to range from 0.5 to 1.5% of the original loan amount. Using our $200,000 example, that would tack on an additional $1,000 to $3,000 each year until a loan-to-value ratio of 80% is reached.
In this scenario, increasing your down payment instead of paying for points could be the more ideal solution, because it will get you closer to reaching the 80% loan-to-value ratio required to cancel PMI. On that $200,000 loan, increasing your down payment from 5% to 10% would not only reduce your principle (in other words, your money would go straight to the loan instead of the bank), it could also reduce the length of time you have to make PMI payments by almost two years, thus saving you more money.
Mortgage Points are Specific to the Individual
To know if purchasing mortgage points is the best option for you, it’s important to consult your lender to calculate the savings versus cost for your specific situation. An experienced lender will be able to weigh the options of a larger down payment versus paying for discount points, and also help navigate more complex scenarios such as loans for investment properties. In the meantime, if you’re looking for more insights into the mortgage process, visit the Homes.com Mortgage Hub.