Mortgage loans are not just the sum of the interest rate and the loan amount. Instead, they often include mortgage points. Even if you get a loan without points, points will have affected the price you pay.
What Is A Mortgage Point?
A mortgage point is a fee that you pay as part of your mortgage loan. One point is equal to one percent of the loan amount. Lenders can charge points on a mortgage loan, increasing the fees you will pay. It is also common for lenders to charge points as fractions for figures such as 1.25 or 2.75 points.
When lenders advertise rates, the rate often includes points. This is why it is important to shop around for a loan. Different point combinations will create different fees and monthly payments. Before making a final decision on a loan, be sure to look over all the details and not just the interest rate.
To figure out how much a point is worth, just follow this equation: Loan amount x .01 = Point amount. So, if you are taking out a $125,000 loan, your point amount would be $125,000 x .01 or $1,250.
Kinds Of Points
Discount points help you discount your interest rate by paying up front. The more points you are willing to pay upfront, the lower your interest rate will be. The opposite is also true. If you prefer not to pay points, your lender will increase your interest rate accordingly. Each point typically lowers your interest rate by a quarter of a percent for a fixed loan and 0.375% for an adjustable rate mortgage. When it comes time to do your taxes, discount points are tax deductible.
Origination fees are points that the lender charges to help them recover the cost of creating the loan for you and pay their brokers. Â Not all lenders use origination points. Those that do are often willing to negotiate the fee. Origination points are typically not tax deductible. The IRS states that an origination fee that was only used to obtain the mortgage and not pay closing costs is tax deductible, but if the fee went for items that would typically be itemized on a settlement statement, it is not deductible. If you pay origination fees, talk with your tax accountant before filing your taxes.
Should You Pay For Points?
How do you determine whether you should pay for points and how many points you should pay? That depends on two main factors: How long do you plan to live in your home and how much money do you have for closing costs?
If you plan on living in your home a long time, then you will get better savings by purchasing discount points. Let’s look at an example:
On a $125,000 mortgage with an interest rate of 5%, the monthly mortgage payment would be $671.03. If you chose to pay three points to lower your rate to 4.25%, you would pay $3750 in upfront costs and your mortgage payment would be lowered to $614.92.
The difference is your monthly payment is $56.11. To break even on the point purchase, you would need to keep your home 67 months or 5 ½ years. Once you’ve lived in your home for that amount of time, you are now saving $673.32 a year, or slightly more than a house payment a year. On the other hand, if you plan to live in the home for shorter than 5 ½ years, then you would want to go with fewer points.
Of course, paying for points can only happen if you can afford them. For many people, having enough money for the closing costs and down payment take everything they have. On the same $125,000 home, a typical down payment would be 20% or $25,000. Typical closing fees run around 3% or $3750. Trying to come up with another $1250 per point may be beyond reach.
Finding The Best Rate-Point Combination
It will be up to you to determine which combination works best for you. If you don’t have a lot of cash on hand, then finding a loan with few points is going to be right for you. If, on the other hand, your income is on the borderline, finding the lowest possible rate so that your mortgage payment doesn’t seem excessive to your income is the way to go. This would mean purchasing as many discount points as possible.
Another factor to consider is what else you might be able to do with the money instead of paying for points. This is known as opportunity cost. For instance, you might decide to invest the $3750 in the stock market rather than pay for points in hopes that you will generate a higher return than the amount you saved. Or you might be aware of a large expense looming in your near future where that money would be better spent. No one can determine for you what is best. However, understanding points and their function will help you find the mortgage that works for you.
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