If you’ve been speaking with a loan officer or are looking into buying a home, you may have heard the term, points, before. But what does this mean? What are points in terms of a mortgage?
What are mortgage discount points?
Discount points are a way to lower your interest rate by paying an upfront fee. This fee is added to your closing costs and included in your total cash-to-close. You pay a percentage of your total loan amount and are able to get a lower interest rate than you would get by not paying any points at all (this is called a par rate, which we’ll discuss next).
Each point will typically lower your interest rate by 0.25%, although this is not a set-in-stone amount, just what we usually see when looking at points.
Discount points are listed at the very top of every closing cost breakdown in most loan disclosure paperwork that you receive during the loan process including:
- Initial disclosures
- Updated interim disclosures
- Initial closing disclosures
- Final closing disclosure
They also should be discussed with you and talked about when receiving your first loan estimate and if any changes are made to your interest rate lock throughout the process.
What is a par mortgage rate?
A par mortgage rate is an interest rate that you receive on your loan for NO CHARGE. This rate is essentially “free” for you to get. It is an interest rate that does not give you a lender credit, nor does it cost you anything upfront to obtain.
A par rate is not necessarily a bad thing! You can still obtain a low interest rate with NO points included.
Pro tip: Always ask your loan officer if there is a par rate available for your loan!
How to calculate points on a mortgage
Points are calculated as a percentage of your total loan amount. 1 point would be 1% of your loan amount, 2 points is 2% of your loan amount, so on and so forth.
- For example: if you are buying 1 point to lower your interest rate on a loan amount of $225,175, you would be paying $2,251.75, since $2,251.75 is 1% of the loan amount.
- Example 2: You are buying 0.710 points to lower your interest rate on a loan amount of $312,900, you would be paying an extra $2,221.59 in closing costs in order to obtain that rate.
As seen above, points aren’t always a whole number. And they can go down to as low as 0.125%. There are so many possibilities for how many points you could be buying, that’s why it’s important to speak with your loan officer to find out how much you are buying!
How many mortgage points can you buy on a mortgage?
So, now you know that you can buy points to lower your interest rate, so now you are probably wondering – what is the limit to how far I can lower it?
While there is no set limit for how many point you can buy, most lenders will not allow you to buy more than 2 mortgage points.
So why is there a roundabout limit on points? It’s simple, there are both state and federal regulations that limit that amount that a person can pay in closing costs on a mortgage. And since points are rolling into your closing costs, lenders have to make sure that you don’t go over that amount!
For a qualified mortgage (QM), your total points and fees can not exceed 3% of your loan amount. This would put your threshold for buying points lower than the 2 mortgage point basis that we listed above.
When we talk about points and fees having to be less than 3%, this includes:
- Mortgage discount points
- Loan origination fees
- FHA, USDA, VA, etc. funding fees
- Transaction fees
- Credit report fees
- Verification fees (Verfication of employment, verification of rent, verification of assets)
- Processing fees
- Mortgage broker fees
Pros and cons of buying mortgage points
As with anything in this world, buying points is not simply black or white, good or bad. There are pros and cons to buying points.
Some perks to buying points include:
- Lowering your interest rate, thus lowering your monthly payment
- Lower the amount of interest that you will pay total on the life of your loan
- Points can be used as a tax deduction (we’ll talk about this more if you keep reading!)
- Having a lower interest rate could qualify you for a higher pre-approval or could even be the difference in being pre-approved vs. not being pre-approved at all
On the flip side, there are some negative aspects to buying points:
- Having to pay much more in closing costs than you would without
- Creating issues with having enough cash-to-close
- Spending excess money without a great amount of payoff
- Long break-even periods
- Increasing cash-to-close even further if interest rate lock has to be extended
Whether or not buying points is worth it varies for everyone. As with most aspects of obtaining a mortgage, what is best for the borrower should be on a case-by-case basis and discussed thoroughly between you and your mortgage professional or loan officer before making any decisions.
Should I pay mortgage points right now?
Rising interest rates are all anyone seems to be able to talk about now, so with this current market, buying points has become more relevant than it was in recent years.
So should you be thinking about buying points to get a lower interest rate? It depends.
If you have the excess cash AND need to get a lower interest rate in order to qualify or to qualify for more home than you would with a higher rate, then yes, I would say that buying points would be in your favor.
However, if you are simply wanting a lower interest rate at this very moment, I would reconsider, and I have good reason for why I say this.
Interest rates will always ebb and flow. Just as they have risen, it is predicted that they will come down again. While no one can say when or by how much they will decrease, it is very likely to happen.
When these rates drop down again, you can refinance your mortgage with no upfront cost and obtain the lower interest rate that you desire!
Even if you decide not to refinance later on, I still would not recommend buying points unless you have to. While rates are higher than they were in 2020 or 2021, they are still considered to be historically low, and aren’t much different than they were in previous years.
When deciding to buy points, you should also be looking at your break-even time frame, which will tell you how long it will take you to break-even on the amount of money you spent paying for points.
Understanding break-even for points
Simply put, your break-even point is the point in time in which you will start to save money and reap the benefits of buying down your interest rate. It is quite literally the point where you break-even on the money you spent.
As with most things, buying points does not always have the instant gratification that so many of us look for. But there are calculations available to tell you when you should expect to see a difference.
- To determine when you will break-even on your upfront cost, you will look at the difference in what your monthly payment is, compared to what your monthly payment would be without, divided by the cost of your points.
- On a $175,000 loan amount at 5% par interest rate, your total estimated payment could be somewhere around $1,377. Let’s say you can buy your interest rate down to 4.5% for 1.357 points, this would make your monthly payment $1,323.30 and would cost you roughly $2,378 in extra closing costs.
- Now that you have your numbers in front of you, you will do some subtraction and division.
- $1,377 – 1323.30 = $53.70. (This is the amount that you are saving per month)
- $2,378 (your upfront cost) divided by $53.70 that you are paying per month = 44.28 (this is the amount of months it will take you to breakeven
- Since there aren’t partial months, you can round up and say that it will take you 45 months in order to break even on your initial investment of $2,378.
Are mortgage points tax deductible?
If you’ve paid points on your mortgage, you may be eligible to get some of that back in the form of a tax deduction!
The Internal Revenue Service (IRS) will allow you to deduct the full amount that you paid towards points in the year that you paid them (the year you bought your home). There are a few limitations to this however….
- If you have borrowed more than $750,000,000, you may be limited to the amount of points you can deduct. Ask your tax advisor on how to handle these situations and how much you can actually deduct!
There are also requirements that you have to meet in order to deduct your points from your taxes, they are as follows:
- Your mortgage must be on a primary residence – NO investment properties or second homes
- You cannot have borrowed the money used to pay for the points from your mortgage lender
- The amount you paid must be clearly itemized on your closing disclosure
- The points must be a clear percentage of your mortgage amount
- The amount of points paid cannot be excessive for your specific state or area
Be careful of expensive lenders
Not all lenders are built the same. Unfortunately, some lenders will include points in your interest rate without giving you a separate option or mentioning that they are doing it. But how can you avoid this?
Ask your lender for a detailed loan estimate and for an explanation of each fee listed. If there are points involved for your interest rate that you were not asked about nor did you agree to, ask for a par rate to compare to other lenders if necessary.
Doing this will potentially save you a ton of money in extra fees, even beyond points. Some lenders will charge outrageous fees for underwriting, processing, loan origination, etc. on top of not offering par rates.
Rest assured, there are lenders out there who will give you a par rate AND be happy to save you as much money as possible by not charging unnecessary fees!