Points, also known as discount points, are fees paid directly to the lender at closing in exchange for a reduced interest rate on a loan, particularly mortgages. One point typically equals 1% of the loan amount. By purchasing points, borrowers can effectively “buy down” the interest rate, leading to lower monthly mortgage payments over the life of the loan.
Types of Points
Discount Points
Discount points are used specifically to reduce the mortgage interest rate. For each point purchased, the interest rate on the mortgage is typically reduced by a certain percentage, often around 0.25%, though this can vary depending on the lender and the overall market conditions.
Origination Points
Origination points are fees that lenders charge for processing the loan. Unlike discount points, origination points do not reduce the interest rate; they are primarily a way for lenders to cover the costs of loan origination services.
Benefits of Purchasing Points
Reduced Monthly Payments
By lowering the interest rate, discount points can lead to lower monthly mortgage payments, making the loan more affordable over the long term.
Potential Tax Benefits
The interest paid on mortgage loans is often tax-deductible, and in some cases, the cost of the points might be deductible as well. It is advisable to consult a tax professional for specific guidance.
Understanding the Break-Even Point
The break-even point is the time it takes for the reduced monthly payments to equal the initial cost of the points. For example, if purchasing points costs $2,000 and reduces the monthly payment by $50, the break-even point would be 40 months ($2,000 ÷ $50). Borrowers should consider whether they plan to stay in the home past the break-even point before deciding to purchase points.
Example Calculation
Consider a $300,000 mortgage at a 4% interest rate for 30 years:
- If the borrower pays 2 discount points, costing 2% of the loan amount, which equals $6,000.
- This may reduce the interest rate to 3.5%.
Here’s a brief comparison:
- No Points: Monthly Payment = $1,432
- With Points: Monthly Payment = $1,347
In this example, the borrower saves $85 per month. The break-even point for the $6,000 spent on points would be approximately 71 months or about 6 years.
Historical Context
The concept of discount points has been a part of mortgage financing for decades. They became more formalized in the mid-20th century as part of the broader evolution of the housing finance market in the United States. This helped standardize costs and benefits associated with securing a mortgage, making the process more transparent for borrowers and lenders alike.
Applicability
Points are particularly useful for:
- Long-Term Homeowners: Those who plan to stay in their home for several years can benefit the most from purchasing points.
- Buyers in High-Interest Environments: When interest rates are high, points can provide significant relief by lowering the rate.
- Buyers with Extra Cash: Those with available funds at closing might prefer to invest in points to reduce their long-term payments.
Comparisons and Related Terms
Interest Rate Lock
An agreement between the borrower and lender to freeze the interest rate for a certain period during the loan approval process.
Closing Costs
A broad term that includes various fees and expenses associated with finalizing a mortgage, such as application fees, title insurance, and settlement fees.
APR (Annual Percentage Rate)
A broader measure of the cost of borrowing that includes interest as well as other associated fees, including points.
FAQs
Are points worth purchasing for a shorter-term loan?
Can points be financed?
Are points tax-deductible?
References
- “A Consumer’s Guide to Mortgage Points and Fees,” Federal Reserve.
- “Understanding Loans and Mortgages,” U.S. Department of Housing and Urban Development (HUD).
- “Mortgage Points: What’s the Point?” Bankrate.com.
- Internal Revenue Service (IRS) Publication 936, “Home Mortgage Interest Deduction.”
Summary
Points, or discount points, are a financial tool used in the mortgage industry to reduce borrowers’ interest rates in exchange for upfront payments. Understanding their cost, benefits, and the break-even point can help borrowers make informed decisions that align with their financial goals and plans. Proper consideration of points can lead to significant long-term savings and a more manageable mortgage payment structure.
