Mortgage points: What's the point?
The structure of home mortgages varies around the world. Paying for mortgage points is a common practice in the United States and, at least according to anecdotal evidence, it may be a uniquely American approach to home financing. In this article, we'll discuss the different mortgage points and how to make them work for you.
What Mortgage Points Are
Mortgage points come in two varieties: origination points and discount points. In both cases, each point is equal to 1% of the total amount mortgaged. For example, on a $100,000 home, one point is equal to $1,000. Origination points are used to compensate loan officers. Not all mortgage providers require the payment of origination points, and those that do are often willing to negotiate the fee. Origination points are not tax- deductible.
Discount points are prepaid interest. The purchase of each point generally lowers the interest rate on your mortgage by 0.25%. Most lenders provide the opportunity to purchase anywhere from one to three discount points. We will focus mainly on discount points and how they can decrease your overall mortgage payments. It is important to note; however, that when lenders advertise rates, they often show a rate that is based on the purchase of points. If you itemize your taxes, discount points are deductible on Schedule A.
See also: "A Tax Primer for Homeowners"
Should You Pay for Points?
The decision of whether or not to pay for points focuses on discount points and requires being able to understand the mortgage payment structure. There are two primary factors to weigh when considering whether or not to pay for discount points. The first involves the length of time that you expect to live in the house. In general, the longer you plan to stay, the bigger your savings if you purchase discount points. Consider the following example:
- On a $100,000 mortgage with an interest rate of 6%, your monthly payment for principal and interest is $599.55 per month.
- With the purchase of three discount points, your interest rate would be 5.25%, and your monthly payment would be $552.20 per month.
Purchasing the three discount points would cost you $3,000 in exchange for a savings of $47.35 per month. You will need to keep the house for 63 months to break even on the point purchase. Since a 30-year loan lasts 360 months, purchasing points is a wise move if you plan to live in your new home for a long time. If on the other hand, you plan to stay only for a few years, you may wish to purchase fewer points or none at all. There are numerous calculators available on the internet to assist you in determining the appropriate amount of discount points to purchase based on the length of time you plan to own the home.
The second consideration with the purchase of discount points involves whether or not you have enough money to pay for them. Many people are barely able to afford the down payment and closing costs on their home purchases, and sometimes there simply isn't enough money left to purchase points. On a $100,000 home, three discount points are relatively affordable, but on a $500,000 home, three points will cost $15,000. On top of the traditional 20% down payment of $100,000 for the $500,000 home, another $15,000 is often more than people can afford. The Investopedia Monthly Mortgage Calculator is a good resource to budget these costs.
See also: "Mortgages: How Much Can You Afford?"
Are Mortgage Points Worth It?
Some people argue that money paid on discount points could be invested in the stock market and used to generate a higher return than the amount saved by paying for the points. But for the average homeowner, the fear of getting into a mortgage they can't afford outweighs the potential benefit that may be accrued if they managed to select the right investment. Many times, just being able to pay off your mortgage is more important.
Also, it is important to keep in mind the motivation behind purchasing a home. While most people hope to see their homes increase in value, few people purchase their homes strictly as investments. From an investment perspective, if your home triples in value, you are unlikely to sell it for the simple reason that you then would need somewhere else to live.
If your home gains in value, it is likely that most of the other homes in your area have increased in value as well. If that is the case, selling your home will give you only enough money to purchase another home for near the same price. Also, if you take the full 30 years to pay off your mortgage, you will likely have paid nearly triple the home's original selling price in principal and interest costs and, therefore, you won't make much in the way of real profit if you sell at the higher price.
The Bottom Line
Purchasing a home is a major financial decision. Plan carefully. Look at the numbers. Before you start shopping, decide on the amount of the monthly payments that you can afford, and determine exactly how you will get to that payment – whether it's by making a large down payment, purchasing discount points or buying a less expensive home.
Then it's time to shop around. Don't settle for the first mortgage package that you happen to stumble across. There are plenty of banks to choose from and numerous resources, including real estate agents, mortgage brokers, and the internet that can help you shop for the best deal for your situation.