What are mortgage points? Should you pay them?

What is mortgage points

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When people want to find out how much their mortgages cost, lenders often give them quotes that include loan rates and points.

A point is a fee equal to 1 percent of the loan amount. A 30-year, $150,000 mortgage might have a rate of 7 percent but come with a charge of one point, or $1,500.

A lender can charge one, two or more points. There are two kinds of points:

These are actually prepaid interest on the mortgage loan. The more points you pay, the lower the interest rate on the loan and vice versa. Borrowers typically can pay anywhere from zero to three or four points, depending on how much they want to lower their rates. This kind of point is tax-deductible.

This is charged by the lender to cover the costs of making the loan. The origination fee is tax-deductible if it was used to obtain the mortgage and not to pay other closing costs. The IRS specifically states that if the fee is for items that would normally be itemized on a settlement statement, such as notary fees, preparation costs and inspection fees, it is not deductible.

How do you decide whether to pay points, and how many? That depends on a number of factors, such as:

  • How much money you have available to put down at closing.
  • How long you plan on staying in your house.

Points as prepaid interest reduce the interest rate, an advantage if you plan to stay in your home for a while.

But if you need the lowest possible closing costs, choose the zero-point option on your loan program.

A lender might offer you a 30-year fixed mortgage of $165,000 at 6 percent interest with no points. The monthly mortgage principal and interest payment would be $989. If you pay two points at closing (that’s $3,300) you might be able to drop the interest rate down to 5.5 percent, with a monthly payment of $937. The savings difference would be $52 per month. But it would take 64 months to earn back the $3,300 spent upfront via lower payments. If you’re sure you will own the house for more than 5 1/2 years, you save money by paying the points.

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Q: What are mortgage "points"? - J.M., Cadillac, Mich.

A: A point is 1 percent of a home loan. On a $200,000 mortgage, one point would be $2,000.

There are "origination" and "discount" points. Your lender may charge origination points for originating, or launching, your mortgage. Discount points, which lower your interest rate (and thus your payments), are optional.

With them, you pay extra money at the beginning of your loan so that you can pay less over time. The more points you pay, the lower interest rate you get.

Should you opt to pay points when taking out a mortgage? It depends on how long you expect to stay in the home. If you pay a few points and then sell your home after two years, you'll have enjoyed lower monthly payments due to the lower interest rate, but you probably will have paid more than you saved. For example, if you pay $3,000 in points to save $50 per month, it will take you 60 months, or five years, to break even.

Explore various home-buying (and tax, retirement, saving, debt, insurance, etc.) scenarios with online calculators at fool.com/calculators/ and bankrate.com/calculators.aspx.

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What are points, how should borrowers make decisions as to whether or not to pay points, can points be financed, are points tax deductible, how many points will it cost to reduce the rate by 1/4%, how should points affect the way you shop for a mortgage?

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What is mortgage points

What is mortgage points

What is mortgage points

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      Points are an upfront charge by the lender that is part of the price of a mortgage. Points are expressed as a percent of the loan amount, with 3 points being 3%. On a $100,000 loan, 3 points means a cash payment of $3,000. Points are part of the cost of credit to the borrower.

      How Should Borrowers Make the Decision to Pay Points or Not?

      Low rate/high point loans are for borrowers who can meet the cash requirement, and either have a long time horizon or want to reduce their monthly mortgage payment. High rate/low point combinations are for borrowers who don't expect to be in their house very long, or who are short of cash. For greater specificity, calculate the break-even periods using my calculator 11a, Break-Even Period on Paying Points on Fixed-Rate Mortgages, and 11b, Break-Even Period on Paying Points on Adjustable-Rate Mortgages.

      Yes, but it reduces the benefit to the borrower unless the borrower is in a low tax bracket and can earn a high return on his cash. You should never finance points if it pushes the loan amount up to a level that triggers a larger mortgage insurance premium. See Can Mortgage Points Be Financed?

      On a purchase transaction, points paid in cash are fully deductible in the year the loan is closed. If the points are financed, they remain deductible if the cash contribution by the borrower for down payment and other costs exceeds the points. On a refinance, points paid in cash are deductible but the deduction must be spread evenly over the term. If the loan is paid off, the unused portion can be taken in the payoff year. If financed points are not deductible as points, they are deductible as interest. See Are Mortgage Points Deductible?

      How Many Points Must I Pay to Reduce the Interest Rate by ¼%?

      Starting with the base interest rate, which is the rate closest to zero points, expect to pay about 1.5 points on a 30-year fixed-rate mortgage. For example, if the lender quotes 6% at zero points and you want to reduce the rate to 5.75%, it will cost about 1.5 points. To reduce the rate by .375%, .5% or .625%, expect to pay about 2.125, 2.75 and 3.25 points, respectively.

      Paying points to reduce the rate usually yields a high rate of return on investment if the borrower has the loan for 4 years or longer. For a more detailed analysis that covers different types of mortgages, see Is It True That Paying Mortgage Points Doesn't Pay?

      How Should Points Affect the Way I Shop For a Mortgage?

      Before you shop, decide what you want to do about points. If you want to pay points to reduce the rate, you shop rate based on a specified number of points. This has the added advantage of letting loan officers know that you know what you are doing.

      Mortgage Discount Points: What You Need to Know

      What is mortgage points

      When you take out a mortgage loan, you run into a lot of closing costs, and few are optional. Most lenders, however, will give you the option to buy mortgage discount points, which can lower your interest rate. You may also get the chance to receive a negative point credit, though this will raise your interest rate.

      Here’s the lowdown on what mortgage points are, how they work and when you should and shouldn’t use them.

      A mortgage point can be either positive or negative, though positive points are much more common. Buying a positive, or discount, point or receiving a negative point changes your mortgage interest rate. Each kind of point costs 1% of your mortgage loan amount. For example, if you have a $100,000 mortgage, you’d pay $1,000 for one discount point.

      A discount point is essentially prepaid interest: You pay an upfront fee to lower the interest rate on your mortgage. Because purchasing points lowers your interest rate, buying them is often known as “buying down the rate.”

      Discount points may be tax-deductible if the purchase is for your primary residence. Before buying points, you should have your lender give you an estimate for both scenarios — your mortgage closing costs if you buy points and if you don’t — says Ann Thompson, a divisional sales executive at Bank of America. She recommends then taking these two estimates to your tax professional to learn if points are tax-deductible for you and how each option would affect your overall tax situation.

      Negative points, sometimes called rebate points, are different: The lender offers to give you a credit by paying some of your fees in exchange for a higher interest rate.

      This is sometimes called a no-cost mortgage. Negative points can be paid either to a broker as part of his or her compensation or to the borrower to cover closing costs. When a lender offers you negative points, it is effectively saying it’ll cover some of your mortgage fees and charge you a higher interest rate in return.

      The credit from negative points cannot exceed the mortgage closing costs, and these points can’t be used as part of a down payment. Thompson says points can be used to cover some nonrecurring closing costs, such as bank and title fees, but they can’t cover recurring fees like interest or property tax.

      Why would you willingly take a higher interest rate? If you’re short on money needed for closing costs, “you may want to pay a little bit more in interest over the life of the loan to have some of that covered,” Thompson says. Another reason might be if you want to hang onto some cash for improvements before you move in and can afford a higher monthly payment.

      There’s no set amount for how much a point will lower or increase your rate, Thompson says. It varies by the type of loan, the lender and prevailing rates, since mortgage rates fluctuate daily.

      On the day of the interview with Thompson, June 5, buying a point on a fixed-rate loan lowered the rate by a quarter of a percentage point. On an adjustable-rate mortgage, the rate would drop three-eighths of a percentage point.

      At Guaranteed Rate, a national lender, the savings are similar: Buying one point will typically lower your rate a quarter, or perhaps three-eighths, of a percentage point, says Dan Gjeldum, senior vice president of mortgage lending.

      Deciding whether to buy mortgage discount points is always a case-by-case decision, though it typically comes down to two factors: time and money. How long will you stay in the house, and how much can you afford to pay to close your mortgage?

      The key factor is how long you think you’ll stay in the home. Then you can calculate at what point you’ll break even on the cost of the points (use our calculator here for a personalized recommendation on whether to buy points).

      “I don’t personally ever encourage paying points simply because of the fact that it does take so long to make it up, especially for a first-time home buyer,” Gjeldum says. While it can make financial sense for some, first-time home buyers generally don’t hold the mortgage long enough to make up the upfront expense, he says.

      That money may be better spent on improvements like paint, landscaping or new carpets, he adds.

      It may make sense to buy points when you’re purchasing a long-term investment property or a home you plan to hold for many years, Thompson says, since you’ll reap savings after breaking even.

      Here’s an example from Thompson to help demonstrate how long it can take to benefit from buying a point. Say you’re taking out a $400,000 loan. Since one point equals 1% of the loan, buying one discount point would cost you $4,000. So first, decide whether you can afford to pay that $4,000 on top of your existing closing costs.

      Based on mortgage rates the day she was interviewed, Thompson said buying a point would save you roughly $57 a month on your mortgage bill. By dividing the cost of the point ($4,000) by the monthly cost ($57), you determine how many months it would take you to make up the cost of buying the point. In this example, it’s about 70 months, or almost six years.

      That means if you planned to stay in the home for six years, you’d break even, and any longer than that, you’d save money. But if you moved out before then, you’d have lost money.

      Gjeldum says buying points makes sense if the seller is willing to pay for it. Gjeldum and Thompson both say that if an employer is relocating you for work and offering to pay points to buy down your interest rate, it could also be worthwhile since you’re not the one shelling out money.

      But don’t stress. We’ve broken down what you’ll have to pay — property taxes, mortgage insurance, title search fees and more. Closing costs will make more sense once you understand what they cover, and how they protect the biggest investment you’ll likely make in your lifetime.

      The total you’ll pay can vary greatly according to your home’s purchase price. The average homebuyer will pay between about 2% and 5% of the loan amount in closing fees.

      Your lender is required to outline your closing costs in the Loan Estimate and this Closing Disclosure you receive before the big settlement day. Take the time to review them closely and ask questions about things you don’t understand.

      Here’s a closer look at the closing costs you’ll face.

      Appraisal fee: It’s important to a lender to know if the property is worth as much as the amount being borrowed. This is for two reasons: The bank needs to verify that the amount you need for a loan is justified, and the bank also wants to make sure it can recoup the value of the home if you default on your loan. The average cost of a home appraisal by a certified professional appraiser ranges between $300 and $400.

      Home inspection: Most lenders require a home inspection, especially if you’re getting a government-insured mortgage. Before lending you hundreds of thousands of dollars, a bank needs to make sure the home is structurally sound and in good enough shape to live in. If the inspection turns up troubling results, you may be able to negotiate a lower sale price. But depending on how severe the problems are, you have the option to back out of your contract if you and the seller can’t come to an agreement on how to fix the issues. Home inspection fees, on average, range from $300 to $500.

      Application fee: This covers the cost of processing your request for a new loan and includes costs such as credit checks and administrative expenses. The application fee varies depending on the lender and the amount of work it takes to process your loan application.

      Assumption fee: If you take over (“assume”) the remaining balance of the seller’s mortgage, you may be charged a variable fee based on the balance.

      Attorney’s fees: A number of states require an attorney to be present at the closing of a real estate purchase. Depending on how many hours the attorney works your case, the fee can vary dramatically.

      Prepaid interest: Most lenders require buyers to pay the interest that accrues on the mortgage between the date of settlement and the first monthly payment due date, so be prepared to pay that amount at closing; it will depend on your loan size.

      Loan origination fee: This is a big one. It’s also known as an underwriting fee, administrative fee or processing fee. The loan origination fee is a charge by the lender for evaluating and preparing your mortgage loan. This can cover document preparation, notary fees and the lender’s attorney fees. Expect to pay about 1% of the amount you’re borrowing (a $300,000 loan, for example, would result in a loan origination fee of $3,000).

      Points: By paying points, you reduce the interest rate you pay over the life of your loan, which results in more competitive mortgage rates. One point equals 1% of the loan amount. So if the loan were $500,000, a 1-point payment would be $5,000. Generally, paying points is worthwhile only if you plan to stay in the home for a long time. Otherwise, the upfront cost isn’t worth it.

      Mortgage broker fee: If you work with a mortgage broker to find a loan, the broker will usually charge a commission as a percentage of the loan amount. The commission averages from 1% to 2% of the home’s purchase price.

      Mortgage insurance application fee: If you put less than 20% down, you may have to get private mortgage insurance. (PMI insures the lender in case you default; it doesn’t insure the home.) The application fee varies by lender.

      Upfront mortgage insurance: Some lenders require borrowers to pay the first year’s mortgage insurance premium upfront, while others ask for a lump-sum payment that covers the life of the loan. Expect to pay from 0.55% to 2.25% of the purchase price for mortgage insurance, according to Genworth and the Urban Institute.

      FHA, VA and USDA fees: If your loan is insured by the Federal Housing Administration, you’ll have to pay FHA mortgage insurance premiums; if it’s insured by the Department of Veterans Affairs or the U.S. Department of Agriculture, you’ll pay guarantee fees. FHA insurance premiums are about 1.75% of the loan amount, while USDA loan guarantee fees are 2%. VA loan guarantee fees range from 1.25% to 3.3% of the loan amount, depending on the size of your down payment.

      Annual assessments: If your condo or homeowner’s association requires an annual fee, you might have to pay it upfront in one lump sum.

      Homeowner’s insurance premium: Usually, your lender requires that you purchase homeowner’s insurance before settlement, which covers the property in case of vandalism, damage and so on. Some condo associations include insurance in the monthly condo fee. The amount varies depending on where you live, your home’s value, and whether it’s in a potential disaster area (such as a flood plain or earthquake zone).

      Property taxes: Buyers typically pay two months’ worth of city and county property taxes at closing.

      Title search fee: A title search is conducted to ensure that the person selling the house actually owns it and that there are no outstanding claims or liens against the property. This can be fairly labor-intensive, especially if the real estate records aren’t computerized. Title search fees are about $200, but can vary among title companies by region.

      Lender’s title insurance: Most lenders require what’s called a loan policy; it protects them in case there’s an error in the title search and someone makes a claim of ownership on the property after it’s sold.

      Owner’s title insurance: You should also consider purchasing title insurance to protect yourself in case title problems or claims are made on your home after closing.

      Paying Mortgage Points: What’s The Point?

      What is mortgage points

      To Pay Or Not To Pay Mortgage Points – How To Decide

      When mortgage rates rise, borrowers scramble to find ways to get the lowest possible interest rate. One option is to pay mortgage points to "buy down" your interest rate.

      "Buying down" the rate means paying extra fees to your lender (these are called "discount points") to get a lower interest rate and payment.

      When interest rates are very low (as they've been in the last few years), few borrowers pay higher closing costs to go even lower. But as mortgage rates rise, borrowers are more likely to weigh the pros and cons of paying points to lower their mortgage rate.

      The decision to pay or not pay mortgage points depends on several factors, and ultimately comes down to simple math.

      A mortgage point or discount point is equal to one percent of your loan amount. That's $4,000 for a $400,000 mortgage. Essentially, you prepay interest upfront in exchange for a lower mortgage payment.

      The rate reduction you get per point depends on your loan and market conditions. Typically, for a 30-year fixed-rate loan, a discount point gets you a .125 percent to .25 percent lower mortgage rate.

      However, the relationship between discount points and interest rate reduction is not perfectly symmetrical. Even for the same loan.

      How To Shop For Loans With Mortgage Points

      As of this writing, for instance, one national lender offers a 30-year fixed loan at 4.5 percent with no points. You can knock .25 percent off that and get 4.25 percent by paying half a discount point.

      But a 4.125 percent rate (just .125 percent lower) costs an additional point. Paying more doesn't necessarily get you a better deal.

      When shopping for a mortgage with discount points, the easiest way to compare offers is to decide how much you want to spend, then see who offers the lowest rate at that price.

      Alternatively, you can decide what rate you want, and see which lender charges the least for it.

      If your income is too low for you to qualify for the house you want, you may be able to qualify with a reduced interest rate and payment.

      If you have the cash available, or if you can convince a home seller to pay discount points for you, buying down your rate may help you qualify for your mortgage.

      Paying mortgage points can save you money over the life of your home loan if you don't sell or refinance for many years.

      Understand, though, that the upfront investment can be substantial.

      Suppose it costs two points ($8,000) to reduce the interest rate on a $400,000 30-year fixed-rate loan from 4.5 percent to 4.0 percent. Your monthly payment for principal and interest would be $117 lower with the lower rate ($1,910 instead of $2,027).

      Should you pay the points if you keep your house for five years? You can figure it out by using a mortgage amortization calculator.

      After five years, with the 4.0 percent loan, you'll have paid $76,370 in interest, plus $8,000 in mortgage points, for a total of $84,370. You'll have reduced your principal balance by $38,210.

      With the 4.5 percent loan, you'll have paid $86,236 in interest. You'll have reduced your principal balance by just $35,368.

      In this case, then, it will cost you $1,888 less over five years if you pay the discount points. But that's not all. You'll have reduced your balance by an extra $2,842. So your total savings in five years is $4,730.

      One more advantage of paying mortgage points is that, since they represent prepaid interest, they are typically tax-deductible

      Disadvantages Of Paying Mortgage Points

      While lower monthly payments and potential savings over the life of your loan are clear benefits of paying mortgage points, there are some reasons you may be better off not paying discount points.

      First, paying one or more points ties up your cash. If you’re making a down payment of less than 20 percent or have less than 20 percent in home equity when you refinance, you'll probably have to pay for mortgage insurance.

      Have a lender compare the impact of making a larger down payment to reduce or avoid mortgage insurance.

      In addition, the sample calculation does not consider that you may have better uses for that money -- for example, paying off high-interest credit card debt, making investments, or saving for future home improvements.

      You may also want to use that money to invest in other assets than real estate for diversification, to boost a college tuition fund or to pad your retirement account.

      The money you pay towards lowering your interest rate may not bring the same rewards as other investment vehicles, but if you plan to stay in your home for the long-term, a lower interest rate could be a smart move.

      Current mortgage rates depend in part on what you're willing to pay for your home loan. In general, the more you pay, the lower your interest rate should be.

      And remember, the lowest rate isn't always the best deal. A good loan professional should be able to help you sort through your options and choose the lowest-cost program for your needs.

      The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.