Mortgage Points: What They Are and How They Work
Mortgage points, also known as discount points, are fees that borrowers can pay to lenders at closing in exchange for a lower interest rate on their mortgage. Each point typically costs 1% of the total loan amount and can reduce the interest rate by 0.25% to 0.5%, depending on the lender and the current market conditions.
Should You Buy Mortgage Points?
Whether or not to buy mortgage points depends on a variety of factors, including the borrower’s financial situation, the current interest rate environment, and how long they plan to stay in the home. Here are a few things to consider:
Financial Situation: If a borrower has the money to pay for mortgage points upfront and it won’t put a significant strain on their finances, then it may be worth considering. However, if the borrower needs to preserve their cash for other expenses, then it may not be the best option.
Interest Rates: If interest rates are low, it may not be necessary to buy mortgage points, as the borrower can likely get a good rate without paying extra fees. However, if interest rates are high, then buying points can make sense, as it can significantly lower the overall cost of the loan.
Length of Time in the Home: If a borrower plans to stay in the home for a long time, then buying points can be a smart financial move, as they will have more time to recoup the upfront costs through savings on the interest rate. However, if they plan to sell the home in the near future, then it may not be worth it to pay for mortgage points.
How Mortgage Points Benefit the Borrower
The primary benefit of buying mortgage points is that it can save borrowers money on their interest payments over the life of the loan. For example, let’s say a borrower is taking out a 30-year fixed-rate mortgage for $400,000 at an interest rate of 4%. If they decide to buy two points at a cost of $8,000, they could lower the interest rate to 3.5%. This would result in a monthly payment of $1,796, compared to $1,910 without the points, a savings of $114 per month.
Over the life of the loan, the borrower would pay $646,624 in interest without the points, versus $578,333 with the points, a savings of $68,291. However, it’s important to keep in mind that the borrower would need to stay in the home for a certain amount of time to recoup the upfront cost of the points.
The Cost Recovery Period
The cost recovery period is the amount of time it takes for the borrower to recoup the upfront cost of the points through savings on their interest rate. The length of the cost recovery period varies based on the loan amount, the number of points purchased, and the interest rate.
To illustrate this point, let’s take a look at a few examples:
Example 1: $400,000 Loan Amount, 2 Points Purchased
In this scenario, the borrower purchases two points for $8,000, reducing the interest rate from 4% to 3.5%. The monthly payment drops from $1,910 to $1,796, resulting in a savings of $114 per month. The cost recovery period in this case would be just under six years, or 70 months.
Example 2: $600,000 Loan Amount, 1 Point Purchased
In this scenario, the borrower purchases one point for $6,000, reducing the interest rate from 4.25% to 4%. The monthly payment drops from $2,955 to $2,859, resulting in a savings of $96 per month. The cost recovery period in this case would be just over five years, or 62.5 months.
How the Cost Recovery Period Should be Taken into Account
When considering mortgage points, it’s important to factor in the cost recovery period. The cost recovery period is the amount of time it takes for the savings from purchasing points to exceed the initial cost of the points. In other words, it’s the amount of time it takes for the borrower to break even.
As a general rule of thumb, if the borrower plans to stay in the home for a longer period of time, it makes sense to purchase points since the savings will outweigh the initial cost over time. On the other hand, if the borrower plans to sell the home or refinance in the near future, purchasing points may not be the best choice since the cost recovery period will be too long.
To calculate the cost recovery period, borrowers can divide the total cost of the points by the monthly savings. For example, if purchasing one point on a $400,000 mortgage results in a monthly savings of $100 and the point costs $4,000, the cost recovery period would be 40 months.
It’s important to note that the cost recovery period may vary based on the interest rate and the loan amount. As interest rates rise, the cost recovery period will increase, making it less attractive to purchase points. Conversely, as interest rates decrease, the cost recovery period will decrease, making points more appealing.
Pros and Cons of Purchasing Mortgage Points
Like any financial decision, there are both pros and cons to purchasing mortgage points. Here are a few to consider:
Lower monthly mortgage payments: Purchasing points can result in lower monthly mortgage payments, which can free up funds for other expenses or savings.
Savings over the life of the loan: Over the life of the loan, the savings from purchasing points can add up to significant savings.
Tax deductible: In some cases, the cost of mortgage points may be tax deductible, resulting in additional savings for the borrower.
Higher upfront costs: The cost of purchasing points can be a significant upfront expense for the borrower, which may not be feasible for some.
Longer cost recovery period: If the borrower does not plan to stay in the home for an extended period of time, the cost recovery period may be too long to justify the upfront expense.
Interest rates: If interest rates rise, the savings from purchasing points may be less significant, making it a less attractive option.
Ultimately, the decision to purchase mortgage points depends on the borrower’s individual financial situation and goals. It’s important to carefully consider the pros and cons and to work with a trusted lender to determine the best course of action.
Mortgage points can be a valuable tool for borrowers to reduce their monthly mortgage payments and save money over the life of the loan. However, it’s important to carefully consider the cost recovery period and the individual pros and cons before making a decision. By working with a trusted lender and doing the necessary calculations, borrowers can make an informed decision that aligns with their financial goals.