High mortgage rates and historically high home prices have squeezed housing affordability in recent years. What if there was a way to reduce your monthly payment when buying a home?
Whether you’re looking to buy or refinance a home, your mortgage lender determines your mortgage rate based on criteria such as your credit history and income. If you’re willing to do some careful math, there’s a lesser-known way to get a better interest rate and save money in the long run: buying mortgage points.
What are mortgage points?
When you apply for a home loan, you will have the opportunity to purchase mortgage points or “rate down.” Each point costs 1% of the loan amount and reduces interest by a fractional amount.
“Mortgage points, or discount points, allow you to pay more in closing costs in exchange for a lower mortgage rate,” says Lucy Randall, director of sales at mortgage lender Better.com. “This means you will have a higher upfront fee, but a lower monthly payment over the life of the loan.”
The exact amount a point can lower your rate varies depending on the loan, the lender and the overall investment market. Typically, it’s about an eighth to a quarter of a percentage point, Randall says.
Here’s an example of points in action: Let’s say you were quoted an interest rate of 7% on your $400,000 loan but you were really hoping for a rate of 6.5%. Points could help you achieve this.
Typically, one point will lower your rate by 0.25%, so to lower your rate by 0.5%, you would have to purchase two points. At 1% of the loan amount each, or $2,000, that would mean a grand total of $4,000 to get that 6.5%% rate you were aiming for (and $133 off your monthly payment). The points do not have to be round numbers. If you wanted to lower your rate just a little, you could buy, say, half a point. In the previous scenario, this would mean a rate of 36.375% – a reduction of 0.125.
There are no hard limits on the number of points you can purchase. According to Randall, though, “you will rarely find a lender who will let you purchase more than four.”
Are mortgage points worth it?
Mortgage points clearly have benefits, helping borrowers get a lower rate and save on interest in the long term. But for some, they could be a costly mistake.
“There’s an emotional pull on homebuyers because they think they want the lowest rate available, but it doesn’t always work in their best interest,” says Omeed Salashoor, director of sales and certified mortgage planning specialist at the mortgage company Homebridge mortgages. “Purchasing points works for the buyer when he plans to stay in the home for a significant period of time.”
This last part is key to determining whether points are a smart investment. Since points come with an upfront fee, you’ll need to make sure you stay in your home long enough to recoup the costs. If you know it will be your forever home and you plan to live there for a long time, you’re probably safe.
But if it’s a starter home or you only plan to stay there a few years, that’s where things get murkier.
Let’s go back to our previous scenario, where you paid $8,000 to lower your interest rate to 6%, reducing your monthly payment by $133. You would have to stay in your home at least until you break even to make the investment worth it. In this case, that would be about 60 months, or just over five years. If you’re unsure about holding onto the property for that long, points probably aren’t the best move.
“Paying mortgage points can save you money over the life of your home loan if you don’t sell or refinance for many years,” Randall says. “Understand, however, that the initial investment can be substantial.”
You should also consider how purchasing points affects your down payment. If paying for points would eat up the money you plan to invest, you may want to think twice. Making a down payment of less than 20% would typically mean having to get private mortgage insurance, which costs $30 to $70 a month for every $100,000 you borrow, which can add up.
Why do mortgage points exist?
Mortgage points encourage borrowers to hold on to their loans longer, providing a potentially extended profit period for lenders and investors in the mortgage market.
“The points are beneficial from the perspective of lenders and the investment community because they discourage serial refinancing and prepayments,” says Marina Walsh, vice president of industry analysis at the Mortgage Bankers Association. “This stability is what the investment community is looking for. They know that the loan will not be repaid early, which means they would lose their investment at that time.”
While lenders have no absolute guarantee that a borrower with points will keep the loan longer, there is certainly added motivation to do so. As Walsh says, a borrower who pays for points “has to think long and hard about refinancing.” If they haven’t yet recouped the costs of those points, they could lose money, as well as have to pay additional fees and closing costs to refinance.
It is this potential for extended returns that makes investors willing to accept lower interest rates. Keep this in mind if a lender offers you a lower rate and be sure the points work in your favor, not just that of the investor.
Lender credits
Points aren’t the only way to manage your rate. If you are willing to go in the opposite direction and accept a higher interest rate, your lender may give you credit.
A lender loan works like points, but in reverse, and helps reduce costs at closing. They may make sense if you don’t have much saved up for upfront costs but know you can make a higher monthly payment.
Loans aren’t ideal if you plan to stay in your home for a long period of time because they come with much higher interest costs in the long run. If you plan to stay for a while, we recommend refinancing when possible to reduce costs.
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