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How to use mortgage points to lower your mortgage rate

Mortgage points

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Outlines how mortgage points work, how much they cost and how they can lower your mortgage rate and save you money over the long term of your loan.

What are points in a mortgage?

Points in a mortgage are essentially prepaid interest. Put simply, the lender says that it will give you a lower annual interest rate if you pay them a lump sum in advance. It varies from lender to lender, but in general, paying mortgage points is a good deal if you plan to have the house for at least a few years and can be a help in How to bring your finances under control.

How do mortgage points work?

Mortgage points

Mortgage discount points work as a fee that allows you to lower the cost of your mortgage rate. Buying mortgage discount points allow you to make a financial trade-off between your upfront cost and your monthly payments. The reason why these points are popular with home buyers is because your lender then lowers the interest rate you are charged over the term of your loan.

This process is also known as “buying down your rate”. If you are considering owning your home for the long term and keeping the same mortgage terms, then mortgage points may be an option that can help you save a lot of money in interest over time. 

How much do mortgage points cost?

They generally have a cost equal to 1% of your total mortgage loan for 1 point. The mortgage rate savings that come with purchasing a single point is usually 0.25%. However, although the points generally come in 0.25% intervals, the amount that you may actually get off your interest rate when you buy a mortgage point may vary depending on a number of factors.

These factors can include who your lender is, the type of mortgage you are getting, and your mortgage rate. Even in circumstances where you might not have enough saved up to purchase a full mortgage point, many lenders are flexible and allow you to purchase smaller increments. These increments of a point, such as purchasing half of a point or even 1.5 points can still be ways to help you save on your mortgage rate. 

When sitting down with your lender, The FTC recommends that it can be helpful to get them to quote the cost of a mortgage point in dollar amounts, rather than in number of points. This can make the process simpler to follow.

How much money can mortgage points save you?

Even small reductions in mortgage rates can lead to large savings over time. For example, you have a mortgage amount of $300,000 at a 3.5% interest rate. Your mortgage term is 30 years. You purchased 1 mortgage point for 1% of your mortgage amount ($3000). Your mortgage rate is now lowered 0.25% to an interest rate of 3.25%.

Over time, the $3000 you paid up front will save you an average of $41.52 per month. If you stayed in your home over the full 30 year term, you will have saved $14,945 in interest! Even if you only stay in your home 10 years, you would have broken even on the cost of your mortgage point in ~6 years, meaning it was a smart decision to purchase. See the table below for an example of how to calculate mortgage points.

No PointsBuy 1 PointBuy 2 Points
Loan Amount$300,000$300,000$300,000
Mortgage Rate4%3.75%3.5%
Points Cost$3,000$6,000
Monthly Payment$1,530$1,490$1,460
Total Interest$172,485$160,130$147,975
Lifetime Savings$12,355$24,510

Factors to consider when thinking about buying mortgage points

For those considering the option of purchasing mortgage points when you are getting your mortgage, there are a number of factors to consider when deciding if it makes sense in your situation. Since you can only purchase them at the time you are closing your mortgage with your lender, some factors to consider in advance can include:

1. If you have the funds ready for the mortgage point after paying your down payment, closing costs, and for any renovations or furnishings you want for when you move into the property;

2. How long you plan on staying in the house, and how long it will take to recoup the original cost (break even) for buying a mortgage point. Generally, if you plan on staying in your home for at least the time it would take to break even, then purchasing the points should be explored;

3. If you do not plan on refinancing before you at least break even on the cost of mortgage points;

 4. If you have a relatively stable income and will not need the extra savings that you use upfront on the cost of a mortgage point. This is especially important to consider after reviewing your savings account and your monthly expenses after buying your home; and

5. How much money you are putting as a down payment, considering that if buying a mortgage point hinders your ability to put a 20% down payment on the house, the savings you get from a point may not outweigh the cost of private mortgage insurance.

Are mortgage points tax deductible?

According to the Internal Revenue Service (IRS) rules, you can get a mortgage points tax deduction. Mortgage points are considered to be prepaid interest and therefore may be deductible, if you are able to itemize your deductions on Schedule A (Form 1040), Itemized Deductions. As a rule of thumb, if you are able to legally deduct all the interest paid on your mortgage, you may also be able to deduct all of the points you have paid.

However, you won’t be able to deduct all the entire amount your paid interest and points if your debt for acquiring your home is greater than the limit allowed for your filing status. In that case, to work out your deductible points, refer to the IRS  Publication 936, Home Mortgage Interest Deduction.

In summary

Overall, the benefits of purchasing a mortgage point should outweigh the costs and should fit with your own personal goals at the time. They can be a smart way to lower your mortgage rate, and should be explored before it comes time to buy a house and will help you when you need to know How to pay for home improvements.