What Are Mortgage Points And When Does It Make Sense to Pay Them?

If you’ve been researching mortgage loans for any length of time, you’ve probably encountered a discussion on mortgage points. Perhaps you’ve heard that borrowers can reduce their interest rates by paying points at closing. While this may be true, it’s important that you understand what mortgage points are and how they work. That’s exactly what we will discuss in today’s lesson.

What Is a Mortgage Point?

Within the context of mortgage loans, one point equals 1% of the loan amount. For instance, on a home loan of $200,000, one point would come out to $2,000. In many cases, borrowers can pay points at closing to secure a lower interest rate on a mortgage loan.

Think of it as a form of prepaid interest. You are giving the lender some cash upfront to get a lower rate over the long term. It’s an upfront investment that could lower the long-term costs of your loan. They are also referred to as “discount points,” because you are lowering (or discounting) the interest rate.

On average, a single point will reduce the mortgage rate by a quarter of a percent. This amount varies, so be sure to check with your lender.

When Does It Make Sense to Pay Them?

We’ve covered the basic definition of a mortgage discount point: It equals 1% of the loan amount. It’s a way to reduce your interest rate. But when does it make sense to pay them? This will come down to two things — how much cash you have up front, and how long you plan to keep the loan. A bit later, we will do the math to see how it all works.

If you only have enough money to cover your down payment and closing costs, this entire discussion is a moot point (pun intended). On the other hand, if you have some extra cash set aside, you might be in a position to “buy down” your interest rate. This might save you thousands of dollars over the life of the loan, depending on how long you keep it.

When considering mortgage points, you must ensure you will reach and exceed your “break-even point.” This is where the money you save on your monthly payments (by reducing the interest rate) exceeds the extra amount you paid at closing in the form of points.

Let’s look at some examples using real numbers:

Let’s say you decide to pay discount points at closing to lower your rate. Your lender tells you it will reduce your monthly payments by $50 a month. In order to accomplish this, you had to pay $1,200 in mortgage points.

These are the two items you need to calculate your break-even point. You paid $1,200 extra at closing to reduce your monthly payment by $50 a month. So you’re ready to do the math.

If we divide 1,500 by 50, we get 24. This means it will take 24 months of monthly savings to reach $1,200. Two years into the repayment term, your monthly savings will add up to the amount you paid in mortgage points at closing. So everything beyond two years is real savings. After two years, you will be paying $50 less a month than you would have if you didn’t purchase any points at all. Thus, the benefits of this strategy increase over time, starting at the two-year mark.

Your long-term plans are the key to all of this. You must hold onto the loan long enough to reach your break-even point. Otherwise, you are losing money by paying mortgage points at closing.

Additionally, you need to consider your cash reserves. When you pay points up front, you are reducing the amount of cash you have on hand. This may benefit you down the road. But it doesn’t do anything in the short term but cost you money. If you have plenty of extra cash, this might not be a concern. On the contrary, if those extra points are going to wipe out your savings, you need to tread carefully.

This article answers the questions: What is a mortgage point, and when does it make sense to pay them? This article provides a basic overview of the subject. We encourage you to conduct additional research into this subject, before making a final decision. Also know that we add new mortgage tutorials to this website every week. If you would like to research another topic, simply type it into the search box located at the top of this page.