Mortgage Points
Mortgage points, also known as discount points, are fees paid directly to a lender at closing in exchange for a reduced interest rate on a mortgage loan. Essentially, this is a form of prepaid interest. By paying money upfront, the borrower “buys down” the interest rate for the life of the loan, which results in lower monthly payments. One point typically costs 1% of the total loan amount and generally lowers the interest rate by approximately 0.25%, although this ratio can vary based on market conditions and lender policies.
Purpose and Function
The primary purpose of mortgage points is to offer borrowers a strategic way to lower their long-term housing costs. While the upfront cost can be significant, the reduction in the interest rate can save tens of thousands of dollars over a 15- or 30-year mortgage. This mechanism allows borrowers to trade liquid cash today for improved cash flow and lower total interest expenses in the future.
Functionally, mortgage points serve as a lever for customizing a loan. Lenders offer a menu of interest rates: the “par rate” is the standard market rate with zero points. From there, a borrower can choose to pay points to secure a rate below par. This is particularly useful for homebuyers who plan to stay in their property for a long time, as the cumulative monthly savings will eventually surpass the initial cost of the points, a milestone known as the “breakeven point.”
Conversely, lenders may also offer “negative points” or “lender credits,” where the lender pays points to the borrower to cover closing costs in exchange for a higher interest rate. This demonstrates the flexibility points add to the mortgage structuring process.
How It Is Calculated
Calculating the cost and impact of mortgage points is a straightforward percentage-based equation.
The Cost of a Point
One point is equal to 1% of the mortgage amount.
- Formula: Loan Amount x 0.01 = Cost of 1 Point
- Example: On a $400,000 mortgage, one point costs $4,000 ($400,000 x 0.01). Two points would cost $8,000.
The Interest Rate Reduction
While the cost is fixed at 1%, the amount the rate is reduced can vary. A common rule of thumb is that 1 point lowers the rate by 0.25% (25 basis points), but this depends on the specific lender and daily market rates.
- Example: A lender offers a rate of 6.5% with 0 points.
- If the borrower pays 1 point ($4,000), the rate drops to 6.25%.
- If the borrower pays 2 points ($8,000), the rate drops to 6.0%.
Calculating the Breakeven Point
To determine if paying points makes financial sense, borrowers must calculate how long it will take for the monthly savings to recover the upfront cost.
- Scenario: Buying 1 point costs $4,000 and saves $80 per month in mortgage payments.
- Calculation: $4,000 (Cost) / $80 (Monthly Savings) = 50 Months.
- Result: The borrower must keep the loan for at least 50 months (4 years and 2 months) to break even. If they sell or refinance before then, they lose money on the strategy.
Importance in Real Estate Transactions
Mortgage points are a critical tool in mortgage planning and real estate negotiations, offering significant financial implications for all parties involved.
- Tax Implications: For many borrowers, mortgage discount points are tax-deductible. In the year the home is purchased, the cost of the points may be fully deductible as mortgage interest on Schedule A of the borrower’s tax return, provided certain IRS conditions are met. This adds an extra layer of financial benefit to the strategy.
- Lowering Monthly Obligations: In an environment with high interest rates, purchasing points can be the difference between an affordable monthly payment and one that strains the budget. It can also help a borrower qualify for a loan by lowering their debt-to-income (DTI) ratio just enough to meet underwriting guidelines.
Seller Concessions: Points are frequently a subject of negotiation between buyers and sellers. In a buyer’s market, a buyer might negotiate for the seller to pay for mortgage points as part of “seller concessions.” This lowers the buyer’s ongoing monthly payment without requiring them to use their own cash at closing, making the home purchase more viable.
