What are mortgage points & how do they work?

Discussing mortgage closing costs with a loan officer is pretty much a homebuyer's last opportunity to secure the best possible interest rate on a home loan. One way to lower that rate — and your monthly payments — is by purchasing 'mortgage points.' 

Buying points is an opportunity that doesn't always present itself unless the buyer brings it up, and since many people struggle to save for a down payment and closing costs, adding another fee is usually not an option. But if you've got the cash to invest upfront, buying mortgage points can lower both your interest rate and your monthly payments. That doesn't mean this is the best move for every buyer, however, so let's break it down so that you can decide if purchasing points is a smart move for you.

What exactly are mortgage points?

Mortgage points, sometimes called “discount points,” are a form of prepaid interest available when finalizing your home loan. The buyer pays a fee directly to the lender — effectively “buying a point” — in exchange for a lower interest rate for the life of the loan. 

Buying down the rate can save you a significant amount of money if you plan on owning your home for a long time. Here's what you need to know:

• When you first discuss a home loan with your lender, you'll be offered an initial interest rate depending on your set of circumstances (income, debt, etc.). He or she may then let you know that you can purchase discount points to lower your rate. If they don't bring it up, ask.
• By paying for points, you're basically asking your lender to “discount” the interest rate.
• Typically, one point equals one percent of the loan amount. 
• Generally speaking, a point can lower the loan's interest by one-eighth to one-quarter of a percent. The actual deduction will vary by lender.
• You'll get a tax break on the cost of your point, but it's only deductible once, and only for the year you pay it, not for subsequent tax returns.

Don't confuse discount points with origination points

There is another type of point that lenders may refer to when discussing your closing costs. These are 'origination points,' and they have nothing to do with lowering your interest rate. Here's what you need to know about origination points:

• Origination points are fees that go directly to the lender to pay them for structuring and processing your loan application. 
• They are typically 0.5% to 1% of the total loan amount. 
• You should be told about these fees in advance. If they are sprung at you last minute, like on the day of closing, something's fishy. 
• Unlike discount points, there is no tax-deduction for origination points.

Are mortgage points negotiable?

Some lenders will tell you that points are not negotiable, and that's only partially true. Since origination points differ from lender-to-lender, it might be possible to negotiate them. Discount points are another story, but you could shave off some costs at closing by requesting fewer (if you've asked for more than one). 

Note that this tactic will affect your monthly payments (and not in a good way) as well as the potential savings over the life of your loan. Still, it never hurts to ask if you can do any better on the cost of their points. Market conditions may prove that negotiating is worth the effort.

Should I pay for discount points?  

Because buying down your interest lowers your monthly payments, discount points are tempting. You'll need to have a certain amount of cash on hand, and if you're already strapped from having to pull together your down payment and closing costs — plus the cost of the movers — you may not want to take on the added expense. In some cases, it might make more sense to skip paying for points and instead invest in a kitchen remodel, or landscaping, or save for future home improvement projects.

If you are tempted, though, you'll want to determine your break-even point. To do this, take the total cost of the discount points you wish to purchase and divide it by the monthly savings you're expecting. The result will be the number of months it'll take to recoup the cost of the points. 

Let's work it out. Say you have the funds to purchase one mortgage point to bring your interest rate down a bit. Hypothetically, we'll put that amount at $2000. And let's assume your lender tells you that buying that one point will drop your monthly mortgage payment by $20. Divide the cost of the point by the monthly savings ($2000/$20) lets you know that your break-even is 100 months, or eight years and three months. If you plan on owning the home for at least that long, buying points would be worth it.

Taking the next step

Remember, to determine whether points could work for you, think about how long you plan to own the home, and whether you have the cash available to buy points and still cover your down payment, closing costs and a reserve for furnishings and maintenance without being house-poor. Whether you're getting ready to buy a home or thinking about refinancing, finding the right loan can streamline the application process. A local Movement Mortgage loan officer will be able to answer your questions about points and help you make the right decision. Find one in your area to get started.