Mortgage Points: What They Are and How They Work

Mortgage points allow you to get a lower interest rate on your mortgage, so you may have also heard people refer to them as discount points. Paying in points can be an excellent strategy for homebuyers working with a tight budget. With the reduced interest rate, you'll also pay less for your monthly mortgage payment. It can be an advantage, especially if you intend to stay in your home for the long haul.

Around two-thirds of adults own their homes. FRED Economic Data puts the ownership rate in the U.S. at 65.9% as of Q4 of 2022. That's despite the cost of purchasing a home. Although the median sale price in the U.S. in Q4 of 2022 decreased slightly from the previous quarter, it was still at $467,700.

Not everyone can pay for their home outright, so most people take out mortgages. However, this increases your monthly financial obligations. One way to make homeownership more manageable is to purchase mortgage points.

Mortgage points are fees you pay directly to your lender and become part of your closing costs. There are two kinds of mortgage points: discount and origination.

Discount points, as the name implies, allow you to get a reduced interest rate for a fee. One point is equivalent to 1% of your loan amount, so if you borrow $250,000, a mortgage point amounts to $2,500. Although lenders have their own way of calculating the reduction in interest, it's usually 0.25% for every mortgage point you purchase.

Let's say you have borrowed $250,000 and have a 30-year fixed-rate loan term. With a 3.5% interest, your monthly payments come to $1,123. Purchasing two mortgage points increases your closing costs by $5,000. However, it decreases your interest rate to 3%, making your monthly payment $1,054 for the duration of your mortgage. Over time, you'll save money on interest.

You may have heard of a mortgage origination fee — that's what origination points are. It's a one-time amount you pay your lender upfront. It compensates loan officers for doing different administrative tasks when processing your loan, such as underwriting your loan, pulling your credit score, reviewing bank records and verifying your credit and income information.

There is no standard rate for origination fees, but it usually falls between 0.5% to 1% of your loan amount. Origination points don't affect your interest rate and are not tax-deductible.

Discount points serve as prepaid interest, and purchasing them allows you to receive a lower interest rate from your lender. Your loan amount determines how much a discount point costs — it's always 1% of how much you borrowed. So if you have a $300,000 loan, you'll have to pay $3,000 for every discount point.

Besides helping you secure a lower interest rate (which, in turn, decreases your monthly payment), your discount points are tax-deductible. But keep in mind: homebuyers who take out a mortgage that exceeds $750,000 are typically limited on the amount of interest they can deduct.

Like origination points, you pay for discount points when you settle closing costs. Although you pay a higher amount if you purchase discount points, these additions do not go toward your down payment.

Using mortgage points can help reduce your loan’s interest rate. In turn, that may translate to several benefits to a prospective homebuyer — from a smaller monthly payment to potential tax savings.

Significant Savings

Despite paying a higher amount upfront due to mortgage points, the payoff may be more than sufficient if you plan on living in your house for a long while. An additional $5,000 may save you double since you will pay less interest.

More Manageable Monthly Amortization

A lower interest rate translates to a smaller monthly payment. Using mortgage points works particularly well for fixed-rate mortgages since you'll feel the effect of a reduced interest rate for the lifetime of your loan.

Save on Taxes

You can deduct mortgage interest on your taxes. The same regulation applies to the amount you spend for mortgage points since it's technically prepaid interest. Your best bet is to speak with a tax professional who can help you determine the details.

Using points on a mortgage may seem most costly in the beginning since it requires you to shell out a higher amount upfront. However, you may realize it's worth the extra dollars if you consider how it impacts your payments over time.

Let's look at three situations to see how mortgage points can affect your finances.

As of January 26, 2023, the average interest for a 30-year fixed-rate mortgage is 6.13%. Your lender offers you a slightly lower rate — 6%. A zero-point loan (where you don't use mortgage points) for $300,000 gives you a monthly payment of $1,799, and you'll pay a total of $347,515 in interest over the life of the loan.

Now, if you purchase one mortgage point, it will increase your closing costs by $3,000. In turn, your interest rate goes down to 5.75%. You only have to set aside $1,751 monthly for your 30-year fixed-rate mortgage. The difference might seem insignificant, but you'll save $17,257 in interest throughout the lifetime of your loan.

Imagine if you use two mortgage points. For $6,000, you get a total savings of $34,305 from interest throughout your loan. Plus, you’ll only need to pay $1,703 per month.

With a better understanding of what mortgage points are, it's easy to see the benefits of using them. However, as with all things, it's not for everyone. You must consider several factors to ensure that you get the best possible return on investment from the amount you spend on mortgage points. After all, it will still cost you money upfront.

While there are several situations that make purchasing mortgage points a wise move, there are also a number where it may not be the right choice. Understanding your current financial situation may help you determine whether or not mortgage points are worth the higher closing costs.

Purchasing mortgage points when you're about to close on your home loan can be an excellent idea. Here are some scenarios wherein it can work to your benefit:

• You're purchasing your forever home. You don't have to live in the house you bought forever, but you'll get the most out of your mortgage points if you stay there for a long time. It increases the chances you'll get past your breakeven point and get some ROI.
• Refinancing isn't in your near future. Many homeowners refinance their mortgages in hopes of getting a lower interest rate. However, doing this will change your loan terms, and there's no guarantee that you'll get better interest (unless you want to spend on mortgage points again).
• You have enough funds for the additional expense. Although purchasing mortgage points saves you money in the long run, it increases your upfront cost. Remember, it's on top of your down payment. Plus, there are taxes or a possible origination fee to consider.
• Your credit score isn't the best. A less-than-ideal credit score typically results in higher interest rates. Purchasing mortgage points may allow you to get more competitive rates.

While using mortgage points offers multiple benefits, it isn't the best option for everyone. Here are some scenarios wherein you may end up with the shorter end of the stick if you purchase them.

• You don't have enough funds. Mortgage points cost money. And remember, the price depends on your loan amount. If your objective is to save on interest, but you don't have enough funds to make the upfront payment, you may have to consider other options, such as going for a shorter term. It may increase your monthly amortization, but you’ll end up paying less in interest over the lifetime of your loan.
• It will affect your down payment. It might be tempting to take money out of your down payment to purchase mortgage points. However, reducing it leaves you with a larger balance, which increases your monthly amortization. It's also worth noting that a down payment lower than 20% will require you to pay PMI (private mortgage insurance) for most mortgages, which adds to your expenses in the long run.
• You intend to pay off your loan early. If you've got your payment schedule worked out and know that you're capable of making extra ones, using mortgage points may not be worth your while. Paying off your loan sooner can be a good thing, but since you spent money for mortgage points upfront, it works best if you exceed your breakeven point significantly to maximize your savings.
• You intend to move within a few years. Don't forget to determine your breakeven point if you're planning to purchase mortgage points. If you're only going to move after one or two years, you won't be able to enjoy your savings.

Purchasing mortgage points can be an excellent way to make your mortgage more affordable in the long run by reducing the amount you pay on interest. MoneyGeek included some common questions many borrowers have to help you determine whether it’s the best option for you.