Mortgage Discount Points Explained
When you take out a mortgage to purchase a home, the lender will give you the opportunity to buy points, which can affect the interest rate of your loan. If you decide to buy points, the money you are required to pay upfront when you close on your home will increase drastically. However, the purchase of these points also comes with financial benefits, including a more affordable monthly mortgage payment.
The rules for purchasing points on a mortgage can be complicated so it’s important to understand your lender’s terms and conditions surrounding these discount mortgage points. In some situations, you may receive tax benefits for the points you bought. Discount points may help you save money in the long term depending on your plans for the home purchase.
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What Are Mortgage Points?
Mortgage points are fees that you can choose to pay to a lender at closing to directly lower the interest rate you receive on a loan. When you buy discount points, it’s often referred to as “buying down the rate” because this purchase lowers the interest rate you pay throughout the life of the loan.
When learning what mortgage points are, it’s important to understand the difference between buying these points and making a higher down payment. While both of these expenses are paid to the lender at closing, they have different purposes. A down payment is a payment you make toward the purchase price of the home. It’s deducted from your loan amount, so if you make a bigger down payment, your mortgage payments will be lower because your loan amount is less.
However, when you buy mortgage discount points, you provide a fee to the lender at closing to reduce your interest rate. When you purchase discount points, the money you provide at closing doesn’t affect your loan amount, but does buy down your interest rate. Therefore, discount points can be a good investment if you plan to keep the property for the entire duration of the loan, or at least for most of it.
You’re buying down mortgage rates with points when you purchase these points at closing. You can think of buying a discount point as prepaying interest on the loan. Essentially, you’re providing this interest upfront and in return, the lender lowers the interest you pay over the loan term. The number of points you decide to buy depends on the extent to which you’d like to reduce your interest rate and what you can afford to spend at the time of closing.
Each lender has its own structure for discount points, but generally, one point costs 1% of your loan. Therefore, if your home loan is $100,000, each discount point you purchase will cost you $1,000. The reduction in your interest rate can also vary by lender and you should review these terms before agreeing to buy discount points. Generally, each point you buy will lower your interest rate by one-eighth to one-quarter of a percent.
Origination points are different than discount points because they’re charged to you by the lender at the time of closing. These points are a way for lenders to charge for processing fees and closing costs. You can usually negotiate the number of origination points a lender charges, but these negotiations must be completed before you agree to loan terms.
When you’re shopping your mortgage options around with different lenders, it’s important to ask about origination points before committing to a loan. Keep in mind, these points are also interchangeably referred to as “maximum loan charges” or “loan discounts.”
Mortgage Point Example
Here’s an example of how discount points help to decrease the mortgage interest rate and monthly payments:
A borrower buys a home with a mortgage offering an interest rate of 4.5%, a loan amount of $100,000, and a loan term of 30 years. The borrower will pay $507 each month for the mortgage.
However, the lender offers mortgage discount points at closing that will lower the interest rate by one-quarter of a percentage point and that costs 1% of the loan amount. The borrower buys one mortgage discount point for $1,000. This lowers the loan’s interest rate to 4.25%, which also lowers mortgage payments to $492 per month.
Should I Buy Mortgage Points?
Before you decide to buy mortgage points at closing, it’s important to ensure this investment is financially beneficial to your situation. You’ll need to analyze the cost of a discount point and how much your lender will reduce the interest rate per point you purchase.
Your long-term plans and current closing costs are also factors to consider before you purchase a discount point. If you plan to own the home or investment property for a long time, you can usually benefit from buying discount points. However, if you’re purchasing an investment property that you plan to sell in a few years or you know you’ll be refinancing soon, discount points may not be worth the added cost.
You should also consider your budget and how much money you have access to at closing. In most cases, you’ll already owe a down payment and closing costs. Adding the cost of a discount point or two can make the lump sum you owe on the closing day much higher. If you’re considering reducing your down payment so you can afford to pay for a discount point, do the math first. Decide if the interest rate reduction a discount point would provide will save you enough money to make up for the increase in the loan amount.
Are Mortgage Points Tax-Deductible?
Discount points are tax-deductible as mortgage interest, as long as you purchased a primary residence or a second home that will be rented out to a tenant. However, there are additional characteristics of your purchase that must be met so you can claim your points as tax-deductible, including:
- The home must be used as collateral for the loan.
- Your mortgage can only be obtained to buy, build, or improve the home.
- You must pay the lender directly for discount mortgage points.
- You can’t claim origination points as tax deductions on non-rental properties.
If you pay for discount points when you refinance a mortgage with a lender, you may have to spread out your tax deduction over the duration of the loan.
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