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Should you pay mortgage points?

Elizabeth Rosen
by Elizabeth Rosen, Contributor (@dimespring)

There are many questions that arise during the home buying process, including whether or not you should pay mortgage points. While paying points may make sense for many borrowers, it is not necessarily the best strategy for everyone.

First, we’ll go over the basics of what mortgage points are and what they cost. Then we’ll discuss how paying points can affect your mortgage loan, as well as the reasons to pay points and when you shouldn’t.

Understanding mortgage points

Mortgage points are finance charges associated with the cost of getting a home loan. The most popular type of mortgage points are discount points, which are a form of prepaid interest. Discount points must be paid up-front at closing and are tax-deductible as home mortgage interest. (The other type of points are called origination points and refer to an extra fee charged by some mortgage lenders.)

Each mortgage point is equal to 1% of the total loan amount. For example, if you’re looking at a $200,000 mortgage loan, one point would cost $2,000.

How mortgage points affect your mortgage loan

Paying mortgage points can help lower the interest rate on your mortgage loan. This, in turn, helps decrease your monthly mortgage payments and the cost of your loan overall.

Each point you pay can lower your mortgage rate by up to 1/4 of a percent, depending on the lender. Most mortgage lenders allow a maximum of 3 or 4 mortgage points for a loan.

There are many mortgage calculators available on the Internet to help you compare the costs of paying mortgage points up-front versus having a higher mortgage rate. It’s a good idea to determine the loan’s “break-even” point — in other words, how long it will take the lower monthly mortgage payments to offset the cost of paying mortgage points.

Note that if you make the decision to pay mortgage points, you are somewhat front-loading your home loan — you are essentially choosing to pay more now in order to pay less in the long run. Since points must be paid up-front, choosing to pay points means you will have to come up with more money at settlement.

Things to consider before paying mortgage points

There are a number of things you should take into account before you pay for mortgage points. The following issues should be addressed prior to making any final decisions.

How long you’ll stay in the home: Mortgage points can be used to lower your interest rate, which lowers your monthly mortgage payments. However, since points must be paid up-front, they are really only worth it if you plan on staying in the home (with the same loan) for a while. It’s often recommended that you do not pay points unless you’re going to own the home for at least five years in order to make the cost of the points worthwhile. So ask yourself whether this is a starter home or a home you’ll retire in, consider the stability of your job, and also how strongly you’re rooted to the area (because of family or other circumstances).

How much cash you can come up with: Points are paid up-front at mortgage closing. So if you decide to pay points to lower your mortgage rate, you will have to come up with more money now. Remember that you are already setting funds aside for the down payment, closing costs, and other expenses that come with buying a home. Paying points in addition to those other costs can be too much for some home buyers, in which case you may want to reconsider the size of your down payment or getting a less expensive home.

Looking at it from an investment standpoint: You can also look at the money you’d be paying for mortgage points as an investment. By paying points and reducing your mortgage rate, you are saving a certain amount of money each month, which can add up to a sizeable investment return every year. Alternatively, if your money could be used for something more urgent (such as a tuition bill or home improvement/upgrade), that type of investment might make more sense, and so paying mortgage points may not be as beneficial to you.

Negotiating who pays for points: There are many aspects of your mortgage loan that can be negotiated, provided you are a strong borrower with good financial standing. Even if your credit is not perfect, you may still be able to get the lender to waive mortgage points to close the deal. Additionally, when it’s a buyer’s market (meaning that there is a high supply of homes, but low demand) your negotiating power is even stronger and you may be able to get the seller to pay your mortgage points.

Are you going to want to refinance later? Since paying points helps bring down your interest rate, it can also inhibit your ability to refinance your loan to a lower rate before you reach that magic break-even point. Therefore, you might also want to take potential future rate drops into consideration

Points are tax-deductible: Because mortgage points are a form of prepaid interest, the IRS categorizes them as “home mortgage interest.” Your points are tax-deductible if they meet certain requirements and you itemize your deductions on Form 1040, Schedule A. If you are eligible to deduct all the interest on your mortgage loan, you may also be able to deduct all the mortgage points you paid on the loan. For more information, please see IRS Publication 936 (Home Mortgage Interest Deduction).

There are zero-point loans available: You are not doomed to pay mortgage points if they don’t work for your budget. Most lenders also offer zero-point loans for home buyers who have a limited amount of up-front cash. This is often particularly helpful for first-time home buyers.

Do the math: No matter what you are considering, it’s always important to run the numbers several times. There are many different types of mortgage calculators available online, or you can go over the figures with a mortgage lender. Knowing what to expect with your monthly mortgage payments (as well as setting aside extra money for emergencies or surprises) is a major part of responsible homeownership.

Conclusion: Whether or not you should pay mortgage points depends on your particular situation and what you are comfortable with spending. Make sure to shop around for the best deal and discuss the loan’s rate/points combination with the lender. By taking a close look at your finances and addressing the issues discussed in this article, you will be able to determine the best strategy for you.

 

Elizabeth Rosen grew up near Boston and comes from a family of financial planners. She attended Carnegie Mellon University in Pittsburgh, Pa. where she studied professional writing. After graduation, Elizabeth moved to San Francisco where she worked for several years as the senior writer/editor and content manager for an online company. She now lives in Los Angeles working as a financial writer for numerous websites and print newsletters.