What Are Points on a Mortgage and How Do They Work?

Mortgage discount points allow you to save money on your monthly mortgage payment by paying more at closing. While points don't provide an immediate return on investment, they can help you save on interest if you stay in your home long enough to break even.

Here's how mortgage points work and how to determine when they make sense for you.

What are mortgage points and how do they work?

Mortgage points are a way of prepaying interest to receive a lower interest rate. The amount is owed at closing and lowers your monthly mortgage payment for the life of the loan.

One point equals paying one percentage of the loan amount. For example, if you buy a $100,000 house, one point would be equal to $1,000. If you were to buy a $200,000 house, a single point would be $2,000, etc.

The amount of the discount varies between lenders, but the typical drop is 0.25 percentage points. If you buy two discount points, you could lower your interest rate by 0.50 percentage points depending on your mortgage lender.

The difference between origination points and discount points

You may have heard the terms “origination points” and “discount points,” but they're very different costs.

An origination point is the percentage of the loan amount a lender charges for making a mortgage and is due at closing. Origination points may also be referred to as origination fees, and typically cost between 0.5% and 1% of the loan amount. This fee covers the underwriting process and may include other administrative tasks the lender performs when creating a loan for a homebuyer.

Discount points, on the other hand, are an optional fee paid at closing that buyers can choose to pay in exchange for a lower interest rate over the life of the loan.

How to calculate the cost and savings of buying points

You can use a mortgage points calculator to determine whether buying points makes sense.

To use a mortgage points calculator, you'll need to know the following information:

• Loan amount
• Loan term
• Original interest rate
• Amount of points purchased
• New interest rate with points

Once you insert this information, the calculator should tell you the amount of months it will take to break even. It should also tell you the total amount of interest you'll pay over the life of the loan, as well as the total amount you'll save.

For example, if you buy a $250,000 home and purchase two discount points to lower your rate from 8% to 7.5%, your monthly payment would drop from about $1,834 to $1,748. With this $86 in savings, you would reach the break-even point in about 58 months.

When should you consider buying mortgage points?

You should consider buying mortgage points when you plan to stay in your home long enough to break even.

Using a discount points calculator, you can plug in how much you're planning to spend on mortgage points. How long would it take for you to start saving on a $300,000 home loan vs. a $400,000 loan?

“Either way you go is a bet,” says Steve Hill, a mortgage broker with SBC Lending. “Nobody can predict the future, so you have to make your best educated decision based on the information you have. With discount points, you're betting that you'll be in the loan long-term.”

If you're considering purchasing mortgage points, make sure you have enough cash to close. You'll typically need to budget for:

• Down payment: Unless you're using a no-down-payment mortgage, you might need to put down 3% to 20% of the home's price
• Closing costs: These include appraisal fees, title fees, and escrow items, and typically cost between 2% to 5% of the home's price
• Buy points: Mortgage points cost 1% of the purchase price and are optional.
• Emergency funds: Make sure you set aside money to cover financial emergencies or repairs.

Jeremy Schachter, a branch manager for Fairway Independent Mortgage Corporation, adds: “Buying points is like an insurance policy. You truly don't know what rates will be in the future, so buying down the rate in today's current environment locks you into a lower rate for the future.”

Pros and cons of paying points on your mortgage

Before you buy mortgage points, consider the benefits and drawbacks first:

Pros:

• Reducing your interest rate can save you money over time
• A lower interest rate means you'll have smaller monthly payments
• Mortgage points are likely tax-deductible

Cons:

• Buying mortgage points increases closing costs
• You might not benefit financially if you move within a few years
• The break-even point may take years to reach
• You may lose out on more profitable investments

“The pros of buying points is that you buy into a lower rate as soon as you close,” Schachter says. “So if rates don't change or even go up, you are locked into a lower rate. However, if you decide to buy down the rate but sell your home before you can recoup the costs, or decide to refinance, buying mortgage points may not be worth it.”

In addition, you'll need to spend money that you could have invested elsewhere. Consider whether the amount you'll save with a lower interest rate is more than you'd have earned from investing it. For example, the average return of the S&P 500 is 10.5% annually. Make sure the potential growth of your money doesn't outweigh your interest rate savings.

“Don't wipe yourself out,” Hill adds. “Leave some money in the bank so you can handle unforeseen expenses. That first year of homeownership comes with a lot of added costs — furniture, landscaping, repairs, etc.”