Many people wonder if they should pay points on a mortgage in order to get a lower interest rate. This is a tough decision because you need to weigh the benefits of paying points against the risks and drawbacks. In this blog post, we’ll discuss what it means for your mortgage when you decide to pay points and how much it may cost you over time. In this article we are going to do a deep dive into the question; “are points on a mortgage worth it?”.
How do Points work in the mortgage process?
Paying points on your mortgage are essentially paying the lender a fee upfront in order to reduce your interest rate. Points are paid at closing and do not need to be paid for ahead of time during the loan application process. Each mortgage point typically costs one percent (1%) of your total mortgage amount. In other words, if you are buying a home with a $400,000 mortgage, one point would cost $4,000. Remember, it is the cost of the mortgage loan itself, not the cost of the home.
How Much Does a Point Save in Interest?
The exact amount of buying points on a mortgage will save on interest is likely going to be a .25% discount per point that you purchase. However, this isn’t totally set in stone and other factors can affect this discount rate. Your lender will likely take in the length of the mortgage, current interest rates, and other factors like the amount of the loan. Make sure that you get specific details from your lender that outlay your exact costs before you get to the closing table.
When Should You Pay Points?
In general, it’s worth paying points on a mortgage only when the savings from a lower interest rate make up for the total number of points paid. In other words, you shouldn’t pay points unless your savings on interest rate outweigh the total number of points you paid. Your final decision will likely depend on how long you plan to own the home, as the benefits will likely not come into play until after you hold the mortgage for a certain length of time. Let’s do some simple calculations below to determine whether or not points will benefit you.
How to Determine the Benefit of Points for You
For the sake of exploration, let’s say that you are going to buy a home for $360,000. In this scenario, you are opting to put down 20% to avoid private mortgage insurance (PMI), and you are going to finance the loan for 30 years. After making this decision, your lender comes back to you with three different options. For the purposes of this example, we are also going to used a fixed rate loan, but remember there are many mortgage types available to you.
Number of Points to Buy
Option 1: Fixed Rate Mortgage of 3.5%, no points
Option 2: Fixed Rate Mortgage of 3.25% 1 point ($3,000)
Option 3: Fixed Rate Mortgage of 3.00% 2 points ($6,000)
First, you will want to determine the difference in monthly cost for each loan, and you do not need to include taxes or insurance in this equation. This will give you a baseline to determine the amount of time it will take to repay the cost of the points.
The difference in Monthly Payments
Option 1: $1347 per month
Option 2: $1306 per month
Option 3: $1265 per month
As you can probably tell, the difference is around $40/month or each drop down in payment. Just for fun, let’s find out how much time it would take to pay back your point investment for each option.
Time Needed to Breakeven with Points on a Mortgage
Option 2: $3,000 investment divided by $41/month in savings = 73.17 months or 6.1 years to pay back your investment.
Option 3: $6,000 investment divided by $82/month in savings = 73.17 months or 6.1 years to pay back your investment.
Wait, what? It is basically the same amount of time for one or two points?
Well, here’s the thing, regardless of the number of points on a mortgage you pay, there probably won’t be a dramatic shift in the amount of time it takes to break even. Remember, you’re essentially just paying interest upfront to lower your monthly payment. The most important thing you can do when deciding to pay points or not is to be sure you’ll actually stay long enough to benefit from the points your using. Points are best used for long-term investments or homeownership to really see the upside.
The Difference Between Mortgage Points and a Down Payment
Mortgage points on a mortgage don’t affect the equity or the amount you will owe on your mortgage. Your down payment will go directly to offsetting the cost of the home, and if you were to sell the home you would retain that equity and get that money back at closing (minus other fees or costs). However, points will disappear if you sell your home and there will be no future benefit beyond your monthly savings. This is why it is so important to make sure you understand the benefits and the risk.
Wait, I forgot to Buy Points Before Closing! Is it Too Late?
Unfortunately, yes it is too late to buy points after the mortgage has closed. However, if interest rates have decreased and you plan to stay in your home for a while, it may be worthwhile to explore refinancing your home and determining whether or not purchasing points are right for you going forward. This may be an effective way to reduce your monthly payments or pull out equity.
Download My Points Google Sheet Calculator
I put together a very simple Google Sheet template to calculate the amount of time it will take to benefit from points. Remember to save the template to your own google account, since the main sheet is locked. Nerwallet also has a nice calculator that allows you to find out the number of years it will take to offset your point cost.