As you shop around for a mortgage, you want the lowest possible mortgage rate. A lower mortgage rate can mean a savings of tens of thousands of dollars on your home loan.
Eventually, though, you end up with the lowest rate available to you. What are your options then?
If you still want to see how low you can go, it’s possible to “buy” mortgage points in an effort to gain an edge.
What are mortgage points?
When talking about saving money on mortgage interest, you might hear talk of “buying down the mortgage” or paying “discount points.” These are both mortgage terms that refer to the practice of paying for mortgage points.
If you buy mortgage points when you close on your home, you get a lower interest rate. The lender quotes you a rate, and then you can purchase a reduction in the interest in order to get an even lower rate.
One mortgage point is equal to one percent of your mortgage amount. So, if you get a mortgage for $200,000, one mortgage point is equal to $2,000.
Not only can you buy points to get a better interest rate on your home loan, but you might also get a tax deduction. The points you pay are considered part of your mortgage interest, so consult with your tax professional to see if you can deduct points to get even more value out of your mortgage points.
How much do mortgage points reduce your rate?
Of course, what you really want to know is how much your rate will drop with each point you buy. According to the National Association of Realtors (NAR), a point reduces your interest rate by between 0.125 percent and 0.25 percent. The deal you get depends on your mortgage terms and the lender. However, NAR says 0.25 percent is typical.
Let’s say you’re getting a 30-year mortgage for $225,000. Your interest rate is 4.15% and each point reduces your rate by 0.25 percent. If you decide to pay two points ($4,500), your rate will drop 0.50 percent to 3.65%.
That seems like a good deal — especially if you plan on staying in your home for a long period of time. But before you jump at paying for points, always run the numbers.
Are mortgage points worth paying?
Whether or not paying points is worth it depends entirely on your plans to buy a house. In general, the longer you plan to stay in the home, the more likely you are to benefit from paying points.
Consider the above example. Using a mortgage calculator, you can figure that sticking with the 4.15% rate will result in a monthly payment of $1,094. Over the course of 30 years, you will pay almost $164,000 in interest.
Now, what happens when you pay that $4,500 to buy down your mortgage rate? Your monthly payment drops to $1,029. That seems like only a small difference, but you end up saving more than $20,000 in interest over the life of your mortgage. If you stick with it for 30 years, there’s no doubt that spending $4,500 now to buy down your mortgage can save you big bucks.
But what if you don’t stay in the house for the full 30 years? You’re saving $65 a month with your lower mortgage rate, totaling $780 per year. At that rate, it will take almost six years to break even with your original $4,500 point purchase. If you plan to move after a few years, paying that much up front to reduce your mortgage rate might not be worth it.
What about increasing your down payment?
What if, instead of paying mortgage points, you just increased your down payment by $4,500?
You borrow $220,500 instead of $225,000. Could that be a better use of your chunk of change?
In this scenario, your monthly mortgage payment would be $1,072, saving you $22 a month. At that rate, it will take you 17 years to break even. Over the course of 20 years, you won’t even save $3,000 in interest over your original loan amount.
In this case, if you have extra money to put toward your home purchase situation, the numbers indicate you’ll save more if you use the money to reduce your interest rate rather than increase your down payment.
What if you just invest that $4,500?
Maybe you don’t put that money into the home purchase at all. If you know you’ll sell your house within 10 years, it might make sense to invest the money instead.
Assuming an average annual return of 8 percent, you could end up with $10,009. That’s your $4,500 earning $5,509 just by sitting there.
Of course, when you invest, you run the risk of loss. But buying a home comes with its own risks. Plus, when you invest the $4,500 is more liquid, rather than being tied up in a home.
Deciding whether or not to pay mortgage points
The key is to consider your options, lifestyle, and how long you expect to remain in the home. Try to figure out the best use of your money by running different scenarios. In the end, only you know how your resources will be put to best use.