Money Talks, So Should You

What are mortgage points?

Elizabeth Rosen
by Elizabeth Rosen, Contributor (@dimespring)

Purchasing a home is a huge financial decision and typically requires the potential buyer to meet with a lending institution and take out a mortgage loan. For the privilege of borrowing this money, the borrower is charged an interest rate (which is paid on a monthly basis, together with a portion of the principal loan balance). Many lenders will present an offer as a “quote” which includes the interest rate and mortgage points.

Mortgage points basics

The term “mortgage point” refers to a charge that the borrower pays in order to obtain a home loan. Mortgage points are paid once and up-front, typically at mortgage closing. If you want to decrease the cost of your mortgage payments, you may be able to pay mortgage points to lower your interest rate.

There are two main types of points that are associated with a mortgage loan — discount points and origination points. One mortgage point is equal to 1% of the home loan amount. So for a $300,000 mortgage loan, one point would equal $3,000.

Discount points are essentially pre-paid interest on your mortgage loan. The more discount points you pay, the lower your interest rate can be. Most lenders will allow borrowers to pay up to 3 or 4 mortgage points, depending on your particular situation and financial strength. Discount points are tax-deductible if you itemize your deductions.

Origination points refer to an extra fee charged by the mortgage lender to cover the costs of arranging your loan. Not all lenders impose this fee, and it is tax-deductible under specific conditions.

The relationship between mortgage points and your mortgage rate

Mortgage lenders typically present their offers in quotes which include both the interest rate and mortgage points associated with the loan. It’s important to understand that the number of mortgage points you pay can be negotiated — although most lenders will limit you to 3 or 4 points.

Paying mortgage points this way can help lower your interest rate, potentially saving you thousands of dollars in the long run. Each mortgage point may lower your interest rate by up to 1/4 of a point (0.25), depending on the lender. But keep in mind that, unlike interest payments, mortgage points must be paid up-front. So if you want your closing costs to be as low as possible, you’ll probably want to avoid paying extra mortgage points.

[See related article “Mortgage Rates vs. Mortgage Points”]

Should you pay mortgage points?

The decision to pay mortgage points depends on a few key factors.

How long will you be living in the home? If you plan on staying there for many years, paying mortgage points is probably a good idea. Since points can be used to lower your mortgage rate, a lower rate means lower monthly payments, thus reducing the overall cost of your loan. The longer you stay in the home, the greater your savings can be. Paying mortgage points to lower your interest rate can end up saving you tens of thousands of dollars over the years!

How much money can you come up with at closing? Buying a home is an expensive decision, even though most of the money is being financed through a mortgage loan. You still have to be able to make a sizeable down payment and pay for closing costs in order to finalize the transaction and move into the house. These expenses (plus the cost of a real estate agent, home inspection, homeowners insurance, and property taxes) often mean there’s little leftover for mortgage points. In this case, you can choose the zero-point loan option if your mortgage lender offers one.

Is the seller willing to chip in? In some cases, particularly in a weak housing market, a buyer may be able to negotiate with the seller over various items, including mortgage points. A number of sellers are willing to pay a portion of the mortgage points in order to get their place sold. Make sure you are in a strong position to negotiate before making too many demands, but never be afraid to ask!

In the end, you have to consider your particular situation and decide what the best strategy is for you — whether that means paying mortgage points, making a large down payment, or getting a less expensive house.

Mortgage points tax deduction

Mortgage points are a form of prepaid interest and part of the cost of obtaining a home loan. The points you pay may be tax-deductible as “home mortgage interest” if you itemize your deductions (Tax Form 1040, Schedule A).

There are nine main requirements that must be met in order for you to be able to deduct your mortgage points. The IRS outlines these requirements as follows:

  1. Your mortgage loan is secured by your main home (i.e. primary residence).
  2. Paying mortgage points is an established practice in your area.
  3. The mortgage points you paid were not more than the amount generally charged in that area.
  4. You use the cash method of accounting (meaning that you report income in the year you receive it and deduct expenses in the year you pay them).
  5. The mortgage points were not paid for items that are usually stated separately on the settlement sheet (such as appraisal fees, inspection fees, title fees, attorney fees, or property taxes).
  6. The funds you provided at (or before) closing — plus any points the seller paid — were at least as much as the mortgage points charged. This means you cannot have borrowed funds from your lender to pay the points.
  7. You use your mortgage loan to buy (or build) your main home.
  8. The mortgage points were computed as a percentage of the principal mortgage loan amount (typically 1 point is equivalent to 1% of the total loan amount).
  9. The amount is clearly shown as mortgage points on your settlement statement.

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).

Conclusion

There are many factors involved with buying a home, including getting a monthly mortgage payment that you can comfortably afford. Understanding the relationship between your interest rate and paying mortgage points can help you find the best combination for your circumstances. It’s important to consider all your options before you pay mortgage points. Make sure you shop around for the best deal and run the numbers ahead of time so you can minimize surprises and get the most enjoyment from your home buying experience.

 

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.