The structure of home mortgages varies around the world. Paying for mortgage points is a common practice in the United States. According to anecdotal evidence, it may be a uniquely American approach to home financing.
What Are Mortgage Points?
Mortgage points come in two varieties: origination points and discount points. In both cases, each point is typically equal to 1% of the total amount mortgaged. On a $300,000 home loan, for example, one point is equal to $3,000.
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. Discount points are prepaid interest. The purchase of each point generally lowers the interest rate on your mortgage by up to 0.25%. Most lenders provide the opportunity to purchase anywhere from one to three discount points.
Prior to the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, which applies to tax years 2018-2025, origination points were not tax deductible, but discount points could be deducted on Schedule A. Going forward, discount points are deductible but limited to the first $750,000 of a loan. In addition, there is a higher standard deduction, so it's advisable to check with a tax accountant to find out if you could receive tax benefits from purchasing points.
We will focus here on discount points and how they can decrease your overall mortgage payments. Keep in mind that when lenders advertise rates, they may show a rate that is based on the purchase of points.
Should You Pay for Discount Points?
The answer to that question requires an understanding of 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 for a 30-year loan:
- On a $100,000 mortgage with an interest rate of 3%, your monthly payment for principal and interest is $421 per month.
- With the purchase of three discount points, your interest rate would be 2.75%, and your monthly payment would be $382 per month.
Purchasing the three discount points would cost you $3,000 in exchange for a savings of $39 per month. You will need to keep the house for 76 months, or six years, to break even on the point purchase. Since a 30-year loan lasts 360 months, purchasing points is a wise move in this instance if you plan to live in your new home for a long time. If, on the other hand, you plan to stay for only 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 factor to consider 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 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 that $500,000 home, another $15,000 may be more than the buyer can afford.
Using a mortgage calculator is a good resource to budget these costs.
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. In many cases, being able to pay off the mortgage is more important.
Also, keep in mind the motivation behind purchasing a home. While most people hope to see their residence increase in value, few people purchase their home strictly as an investment. From an investment perspective, if your home triples in value, you may be unlikely to sell it for the simple reason that you then would need to find somewhere else to live.
If your home gains in value, it is likely that most of the other homes in your area will increase in value as well. If that is the case, selling your home will give you only enough money to purchase another home for nearly 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 monthly payment amount 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 be sure to shop around. Don't settle for the first mortgage package that you stumble across. There are plenty of banks to choose from and numerous resources, including real estate agents, mortgage brokers, and the internet, to help you shop for the best deal for your situation.