How Mortgage Points Work: Are They Worth the Cost?
When taking out a mortgage, you might come across the option to buy "mortgage points." Understanding what these points are, how they work, and whether they are worth the cost can help you make a more informed decision about your mortgage. This article will explain mortgage points, their benefits and drawbacks, and provide guidelines to help you decide if they are right for you.
What Are Mortgage Points?
Mortgage points, also known as discount points, are fees paid directly to the lender at closing in exchange for a reduced interest rate on your mortgage. Essentially, you are prepaying some of the interest to receive a lower monthly payment over the life of the loan.
Types of Mortgage Points
1. Discount Points
Definition: Fees paid to reduce the interest rate on your mortgage.
Cost: Typically, one point costs 1% of the total loan amount. For example, on a $200,000 loan, one point would cost $2,000.
Rate Reduction: Generally, each point lowers the interest rate by 0.25%, but this can vary by lender.
2. Origination Points
Definition: Fees paid to the lender for processing the loan application.
Cost: Also typically 1% of the loan amount, but these points do not reduce the interest rate.
How Do Mortgage Points Work?
When you buy discount points, you pay an upfront fee at closing in exchange for a lower interest rate on your mortgage. This can lead to significant savings over the life of the loan, especially if you plan to stay in the home for a long period.
Example Scenario
Loan Amount: $200,000
Interest Rate Without Points: 4.00%
Interest Rate With 1 Point: 3.75%
Cost of 1 Point: $2,000
Monthly Payment Without Points: $954.83
Monthly Payment With 1 Point: $926.23
In this example, paying $2,000 upfront lowers the monthly payment by $28.60. To determine if the points are worth it, you would calculate how long it takes to recoup the cost through the monthly savings.
Calculating the Break-Even Point
The break-even point is the time it takes for the savings from the reduced monthly payment to equal the cost of the points.
Break-Even Formula
Break-Even Point (months)=Cost of PointsMonthly SavingsBreak-Even Point (months)=Monthly SavingsCost of Points
Using the example above: Break-Even Point=200028.60≈70 monthsBreak-Even Point=28.602000≈70 months
So, it would take approximately 70 months (or about 5.8 years) to break even.
When Are Mortgage Points Worth the Cost?
1. Long-Term Stay
Extended Duration: If you plan to stay in your home beyond the break-even point, buying points can be a smart financial move. The longer you stay, the more you save.
2. High Loan Amount
Larger Loans: The savings can be more significant on larger loan amounts, making points more worthwhile.
3. Stable Income
Consistent Finances: If you have the upfront cash to pay for points without straining your finances, it can be beneficial.
4. Low-Interest Rates
Future Rate Increases: If you anticipate interest rates will rise in the future, locking in a lower rate now through points can save you money over time.
When Are Mortgage Points Not Worth the Cost?
1. Short-Term Stay
Early Move: If you plan to move or refinance within a few years, you may not stay in the home long enough to recoup the cost of the points.
2. Upfront Cash Constraints
Financial Pressure: If paying for points strains your budget or depletes your savings, it may not be the best choice.
3. Other Investment Opportunities
Alternative Uses of Funds: If you can earn a higher return on your money through investments other than prepaying interest, you might want to consider those options.
4. High Initial Fees
Other Costs: If the overall closing costs are already high, adding the cost of points might not be feasible.
Conclusion
Mortgage points can be a valuable tool for lowering your interest rate and saving money over the life of your loan, but they are not suitable for everyone. Assessing your long-term plans, financial stability, and break-even point is essential in determining whether purchasing points makes sense for your situation. By carefully considering these factors, you can make an informed decision that aligns with your financial goals and homeownership plans.
