How Do Mortgage Points Work?

Buying points can make sense for many home-buyers, but you need to consider how long it will take you to break even on the initial fees that you pay per point.

If you don't plan to stay in your home long enough for your reduced interest rate to cover the cost of the mortgage points you paid for, it doesn't make sense to pay points. If you do plan to stay in your home long enough, you'll often end up saving more on interest over time than the points cost you to buy.

Buying mortgage points

When you buy points, you pay a specific amount of money to your lender in order to get an interest rate reduction. Typically, each point you buy will cost 1% of the total amount of your mortgage. So, if you were borrowing $200,000 and you wanted to buy a point, you'd pay $2,000.

Typically, each point you buy reduces your interest rate by .25%. For example your interest rate might go from 4.5% to 4.25% if you paid for one point on your mortgage. However, the specific amount your interest rate is reduced will vary depending upon your lender and loan program.

If paying 1% of your mortgage to buy a point seems unaffordable, your lender may also allow you to buy half-points. These obviously cost less, and would reduce your interest rate by less. Buying half a point would cost you .5% of the loan amount and would reduce your interest rate by 0.125%.

Points may be tax deductible

When you buy points on your mortgage, this is considered to be “prepaying interest.” As a result, you are typically able to deduct the amount you paid for the points from your federal taxable income.

However, the amount you're allowed to deduct will vary based on how much your mortgage is. If your mortgage is not fully tax deductible because you're borrowing too much money to fall within the IRS limits, you will only be able to take a partial deduction.

As of 2018, for newly initiated mortgages, the maximum loan value in order for interest to be fully deductible is $750,000. If you borrow more than this amount, you'll only be eligible for a partial deduction.

The IRS also indicates you must meet certain requirements to take either a full or partial deduction for points you buy. You can deduct points in the tax year they are paid if:

• The mortgage is for your primary home, or for the home you live in most of the time.
• You didn't overpay for points and paying for points is an established business practice in your area.
• The money you brought to closing, including any seller-paid points, was at least as much as the cost of the points. You aren't able to deduct the cost of points if you borrowed the money to pay for points from your lender or mortgage broker.
• Points were equal to a percentage of the amount of your mortgage and your mortgage settlement statement shows clearly how much the points cost.

Is it worth buying points?

When you consider whether to buy points or not, you need to do a little math to see when you would break even from the purchase. For example, say you were taking out a $250,000 loan and you had a choice between buying 0 points with an interest rate of 4.5% or buying one point and reducing your interest rate to 4.25%.

• If you did not buy points, your monthly payment on a 30-year mortgage would be $1,267 and the total cost of your loan would be $456,071.
• If you bought points, your monthly payment on a 30-year mortgage would be $1,230 and the total cost of your loan would be $442,746.

You would save $37 per month if you paid for a point -- which would cost you $2,500 (1% of $250,000). To determine how long it would take you to break even for buying points, you'd need to divide $2,500 (your cost) by your monthly savings of $37. Based on this calculation, you'd break even or make up for the $2,500 you spent on the point in 67.6 months.

If you remain in your home for longer than 67.6 months, then you're better off for having bought the points because you've made up for your initial $2,500 investment and you continue to enjoy payments that are $37 lower every month.

If you stay in your home and keep paying off your mortgage for 30 years, you'll pay a total of $13,325 less in interest. Even after subtracting for your initial $2,500 investment in buying the point, you end up saving $10,825 over the life of the loan.

That's a substantial amount of savings -- but of course you only realize it if you remain in your home. If your future is not certain and you don't think you'll be staying long enough to break even, you may not want to incur the initial cost of buying the point.

Make sure to comparison shop carefully among lenders

It's important to understand mortgage points not only so you can decide if it makes sense for you to buy points or not, but also because you want to make certain you're comparing apples-to-apples when you take out a mortgage loan.

If one lender is offering you a loan at 4.5% with no points and the other offers you a 4.5% loan with one point, obviously the first loan is a much better deal. With the second lender, you'd be paying 1% of the entire cost of your mortgage just to get the same rate the first lender is giving you for free.

Some lenders also offer negative mortgage points

You also have the option with some lenders to apply negative points to your mortgage. Essentially, this means you increase your interest rate in order to get a credit that you can use to cover closing costs.

For example, if you were taking out a $250,000 mortgage and you applied a negative mortgage point, your interest rate might rise from 4.5% to 4.75% -- but you would get a $2,500 credit to cover costs at closing.

While negative points make your home cost more over time, they can sometimes make it possible to afford to close on a home when you otherwise would be tight on cash. Just be aware that this option is costly.

In the above example where you raised your rate from 4.5% to 4.75%, your $250,000 loan would result in a monthly payment of $1,304 and the total cost of your mortgage would be $469,483.

When compared with a monthly payment of $1,267 and a total cost of $456,017 if you hadn't applied negative points, you pay $37 more each month and would pay $13,466 more over 30 years in exchange for having gotten $2,500 up front.

Do the math on buying mortgage points

Whether you consider buying points to reduce your rate or applying negative points to get cash up front, make sure to do the math to understand the long-term impact your choice will have on your mortgage costs. Your mortgage is probably going to be your largest debt with the biggest monthly payment, so you owe it to yourself to get the best deal possible.