How Do Mortgage Points Work?

Scoring a low interest rate is vital if you want to get the best deal on your home loan. Having a respectable down payment doesn’t hurt. Being prepared to shop around also helps. However, there’s something else that can help you snag a lower interest rate: mortgage points. How do mortgage points work?

To get the most out of mortgage points, you have to understand what mortgage points are and how they work. It also helps to know a bit about the circumstances in which buying them can make financial sense.

Defining Mortgage Points

The term mortgage points can mean a couple of different things, so it’s important to be sure that it’s being used the way that you think it is. As Experian reports, there are two types of mortgage points:

Origination Mortgage Points: These points are actually one-time fees that are owed to the lender as part of your closing costs. They are negotiable. In fact, some lenders offer loans with few or no origination points.
Discount Mortgage Points: These mortgage points are the ones that can help you lower your interest rate. Their purchase is totally optional.

How Mortgage Points Work

How do mortgage points work? When you purchase discount mortgage points, they’re priced as a percentage of your loan amount. Therefore, each point costs 1 percent of the amount you’re borrowing. In return, the lender will lower your interest rate a certain amount. According to Credit Karma, some lenders will even allow borrowers to purchase partial points. Imagine that you’re borrowing $200,000 with an initial interest rate of 5 percent. Your lender has offered you the option of purchasing points, and each point will bring down your interest rate by 0.25 percent. If you purchase one point, it will cost you $2,000, and your new interest rate will drop to 4.75 percent. If you decide to purchase two points, then you’ll need to pay $4,000, and your interest rate for your home loan will fall to just 4.5 percent.

When You Should Consider Paying for Points

As Forbes explains, paying for discount mortgage points involves a bit of a trade-off. By lowering your interest rate, you’ll also lower your monthly mortgage payment and save on the total cost of your home loan. However, your upfront costs will be higher. Some homebuyers who have extra cash prefer to use it for their down payments so that they can build their equity. Equity is a valuable resource, so that’s certainly an understandable impulse. However, as Nolo reports there are also situations where you paying for points can make good financial sense:

You have the funds available to pay for the points.
You want to pay less interest over the life of the loan.
Your credit score is too low to qualify for the lowest rates.
You need to snag a lower interest rate so that your monthly mortgage payment will be more affordable.
You plan to own the home long enough to recoup the cost of the points.
You itemize and want the tax deduction* for the mortgage points.

Paying Mortgage Points vs. Making a Larger Down Payment

How do homebuyers decide whether their extra cash should go toward paying for points or making a larger down payment? According to U.S. News and World Report, you’ll want to run the numbers carefully. The deciding factor may be whether your down payment is large enough for you to escape the requirement for private mortgage insurance (PMI). Lenders generally insist on PMI if your down payment is less than 20 percent, and you’ll continue to pay it until you have 20 percent equity in your home. That can add 1 percent to your loan amount each year. If a small down payment means that you’re going to be paying PMI no matter what, then it’s probably worth exploring whether points could help offset that cost by lowering your interest rate. However, if you’re able to make a 20-percent down payment, you’ll have to consider the best use of your funds carefully.

How Do Mortgage Points Work?