How do mortgage points work

How do mortgage points work?

Discount Points

When comparing mortgage rates you may notice that lenders offer different interest rates based on “points.” So how do mortgage points work?

Mortgage discount points are a percentage-based fee you pay at the mortgage closing date in return for lowering the interest rate.  In the lending world, you may hear discount points also known as “buying down the rate.” The more points you are willing to pay at closing, the lower the interest rate offered.  

The point system lenders use is based upon a percentage value of the cost of the mortgage. Most lenders will charge 1 point at the equivalent of 1 percent of the mortgage amount. On average, paying 1 point will reduce the rate by 0.25% which can be a significant saving throughout a lifespan of a 30-year loan.

Calculating mortgage discount points

Example 1: A 30-year mortgage at 3.75% interest for $250,000 with a 20% down payment and 1 discount point will cost you $2500 extra at the time you close on the house.

Example 2: A 30-year mortgage at 4.0% interest for $250,000 with a 20% down payment and 0 discount points will cost you $0 extra at the time you close on the house.

But let’s investigate further.

Example 1: With a 3.75% interest rate, at the end of the loan the borrower will have repaid $333,443 which includes the mortgage amount plus interest.  

Example 2: With a 4.0% interest rate, at the end of the loan the borrower will have repaid $343,739 which includes the mortgage amount plus interest.  

The math:

$343,739 – $333,443 = $10,296 difference

$10,296 – $2500 = $7,796 savings if you can pay the discount point fee at the time of closing to lower the rate .25%

Origination Points

Origination points are often called origination fees. This is a fee you pay to the lender for initiating and processing your loan. Origination points will typically cost you around 1% of the mortgage amount, but can also be charged as a flat fee determined by the lender.  

Beware: Some lenders offer loans with no origination points to make their offers more attractive. However, often where a lender offers no origination points, you may see higher fees on other items in the closing costs.  

Check out the Mortgage Interest Rate vs APR article to make sure you are taking all fees into account when shopping around for a loan!

Why is there an origination fee? 

Origination points or fees are a way of paying the loan officers who work off commission. They need to get their piece of the pie for preparing the mortgage. 

Because origination fees vary by lender, comparing APRs can determine how the cumulative fees stack up.

Is there any flexibility with origination fees?

Origination fees are sometimes negotiable with a lender but usually come at a cost. Someone looking to lower their closing costs could negotiate a lower origination fee in favor of paying a higher interest rate.  

Why would you negotiate fees?

Negotiating fees may make sense for buyers cash-strapped for closing costs. It can also benefit someone who may know they will only be in the home for a short time before selling. 

Rebate Points:

Not as common as the first two, Rebate points are points paid by the lender that goes toward your closing costs. Rebate points are sometimes called negative discount points.  

Some lenders will even allow you enough rebate points to where there will be no closing costs on the loan. If you are thinking this is too good to be true, it most likely is! 

For every rebate point given by a lender, the interest rate on the loan will increase. Rebate points normally have an inverse relationship to discount points and will increase your interest rate by 0.25% per rebate point.

Rebate points can help a home buyer who once again is short on cash for down payments and closing costs. Another extremely helpful instance where rebate points can be beneficial is refinancing scenarios.

Negative points can allow you to refinance your home at a lower rate without having to pay fees. In an economy, where interest rates are dropping, a homeowner could potentially refinance three times in a single year without paying fees by taking rebate points to get what’s called a “zero-closing cost” mortgage.

When do paying discount points make sense?

Now that you know how mortgage points work, the most popular question people tend to ask is, “Should you buy mortgage points?”  

The short answer to this question is YES, depending on a couple of factors.  If you plan on staying in the house for the entire loan term, discount points are worth considering. Because the longer you remain in the house, the more money you will save with a lower interest rate from buying discount points.

How to calculate a break-even point for a mortgage

Finding your “break-even point” helps determine at what time into your loan paying the discount points becomes worth it.  

In the chart below, we will compare three 30-year mortgage rates. One without and two with points to see where our break-even points are.

how to calculate mortgage points

  *Monthly payment calculations are based solely on interest rates and do not include taxes, insurance, PMI, etc.

The math:

To find your “break-even point” take the cost of your discount points and divide that by the saving per month.

1 point: $3000/$43 = approx. 70 months or about 5 years 10 months into the loan

1.5 points: $4500/$65 = approx. 69 months or about 5 years 9 months into the loan 

What to do once you find the “break-even point”?

After calculating the break-even point, the next step is to predict if you will be staying in your home longer than that period. 

 If you stay in the home longer than the “break-even point”, “buying down the rate” with discount points will have made sense. The longer you stay in the home, the more money you are saving throughout the life of the loan! The savings can add up.  

On the other hand, if you sell before the break-even point, paying the discount points for the home will have cost you more money than it was worth. Oops!

Knowing how long you plan on staying in a home can be challenging. Life throws curve balls and our situations are constantly changing. All we can do is make the best-educated decision at the current time. 

Final Thoughts

Highlighting the pros and cons of mortgage point options before choosing a mortgage will greatly increase the odds of saving money down the road. There is not a clear-cut “correct way” to take out a mortgage. Analyze your situation and carry through with educated confidence that is backed by reason.

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