Mortgage Advice

What’s the Point of Mortgage Points?

June 28, 2013

If you could pay money to get a better interest rate on your mortgage loan, would you? Before you’re quick to answer, “yes,” let’s take a closer look at how discount points work to determine if paying mortgage points is in your best financial interest.

Discount points are a prepaid interest fee that you pay upfront to lower your interest rate. Points are calculated as a percentage of your total loan amount and typically equal 1% of the loan. For example, one point for a $200,000 home costs $2,000.

Although each point generally lowers your interest rate by .25%, there is the potential that you could lower your interest rate by up to .5%. You also have the ability to deduct points as prepaid interest come tax time.

While the idea of paying mortgage points to lower interest rates may intrigue you, there are two key factors you need to take into account before making a decision: your current financial situation and the length of time you expect to live in the home.

Once the down payment and closing costs are accounted for, most people don’t have the luxury of allocating funds toward mortgage points. If you are able to put a portion of your funds toward paying points, you need to consider how long you plan on living at that house. The longer plan on living there, the more you’ll benefit from paying points.

To weigh the opportunity cost of paying points, let’s go back to our example of the $200,000 loan.

For a $200,000, 30-year fixed rate mortgage loan with an interest rate of 6%, your monthly mortgage payment would be approximately $1,199 a month. If you decided to pay one point to lower your interest rate to 5.75%, your monthly mortgage payment would drop to $1,167. This would save you an extra $32 each month, with $8.33 in monthly investment savings, for a true monthly savings of $23.63.

If you take your true monthly savings and divide it by the cost of points (in this case $2,000) you can determine how long you will need to live at that residence to break even. At this rate, it would take you approximately 84 months, or seven years, to regain the money you paid for points.

So, if you plan on living there for seven years or more, then it would be wise to consider paying mortgage points. However, if you plan on relocating in the relatively near future, I would advise you to look at other ways you can improve your interest rate.

When it comes to purchasing a home, you want to carefully consider all of your options. After all, it is one of the biggest financial decisions you’ll make in life. To determine if you should pay points to lower your interest rate, try using our mortgage point calculator.