What Are Mortgage Points?

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What Are Mortgage Points?
Article Excerpt

Mortgage discount points enable homebuyers to save money over the long term. Learn about two different types, typical costs, tax benefits, and more.

The term “points” often appears during the mortgage application process and at closings. It can have at least two meanings, but the most common meaning refers to an optional way for a borrower to reduce the interest rate on the mortgage loan. For every “discount point” the borrower purchases, the interest decreases by a certain amount. The following is an overview of how mortgage points work, and whether discount points are worth the initial expense.

Types of Points

How much is one mortgage point? Generally speaking, one “point” is equal to 1% of the amount of a mortgage loan. One point on a $250,000 mortgage would cost a borrower $2,500, for example. This is how much the borrower pays - not necessarily the amount the interest rate will be lowered by.

Two kinds of points are common in home mortgage loans: origination points and discount points. It’s important to understand these two terms while having discussions with your lender.

wooden family house

Origination Points

Some lenders use points for the fee they collect for making the loan. These are known as “origination points.” Not all lenders charge points for originating a loan. Some charge an origination fee instead. This is part of what your mortgage lender is paid.

The number of origination points may be negotiable based on factors like credit score, debt-to-income ratio, and down payment. The borrower pays these points at closing.

Discount Mortgage Points and How They Work

All figures mentioned, including interest rates, are for illustrative purposes only; they may not reflect obtainable interest rates today.

The more common usage of the term “points” involves “discount points” that a borrower may purchase at closing in order to lower the interest rate on the loan. For every point that a borrower purchases, the lender will reduce the interest rate by a specified amount. The reduction may vary from one lender to another, but a 0.25% reduction per point is common. Borrowers may purchase fractions of points, often down to one-eighth of a point.

Suppose a borrower has been approved for a $400,000 30-year mortgage at 4% interest. Each point would cost $4,000, and would reduce the interest rate by 0.25%. The lender offers to lower the interest rate to 3.625% if the borrower buys 1.5 points, which would cost the borrower $6,000. If the borrower declines the offer, they would pay the original 4% interest rate.

Should you buy mortgage points?

When deciding whether or not to purchase discount points, you need to consider factors like:

  • How long you plan on owning the home

  • How much the mortgage will cost you over the life of the loan

  • How much you could save over time by paying for points now

  • Whether you can afford the points now

laptop and mortgage point

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How much can you save by purchasing mortgage points?

If you take a full 30 years to pay off a $400,000 mortgage at 4%, you will pay a total of around $687,478. If you buy the 1.5 points offered by the lender, your interest rate would be 3.625%, and over 30 years you’d pay about $656,714.

Your $6,000 up-front investment would lead to a total savings of $30,764, albeit 30 years later. That averages out to slightly more than $1,025 in interest that you don’t have to pay each year.

Discount points work the same way on adjustable-rate mortgages (ARMs). You just need a few extra steps to calculate the total cost and potential cost savings.

Are buying mortgage points worth the cost?

If you’re planning on staying in the home for a longer time, it might be worth it from a pure cost perspective. If you plan on buying your “forever” home, buying mortgage points is likely well worth the upfront cost. Your mortgage advisor will map out these scenarios clearly.

An experienced mortgage advisor can run comparison scenarios for you.

Are mortgage points tax-deductible?

Loan origination points are typically not tax-deductible. For this reason, many lenders have moved to different fee structures.

Discount points raise several issues with regard to tax deductions. The interest you pay on your mortgage is tax-deductible. Buying discount points reduces the total amount of interest you will pay. That will, in turn, reduce the amount of your annual mortgage interest tax deduction, but only by a small amount most years.

Recent amendments to federal tax law have made the deductibility of discount points somewhat uncertain. The IRS considers discount points to be prepaid interest. For the tax years 2018 through 2025, discount points for purchase-money mortgages should be fully deductible, but points on certain home equity loans are not. After 2025, only discount points on the first $750,000 of a loan will be deductible.

tax receipt

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Get advice on mortgage points!

The mortgage advisors at The Wood Group of Fairway are here to help package a mortgage solution tailored for you. Your first step is to get started with our easy online form!