Understanding Mortgage Points: How They Are Paid and Their Benefits

When getting a mortgage, you may hear the term “mortgage points” thrown around. But what exactly are mortgage points, and how do they work? 

Mortgage points, also known as discount points, are fees paid to the lender at closing in order to reduce the interest rate on the mortgage. Essentially, mortgage points allow the borrower to “buy down” the interest rate on their loan. 

Paying points upfront can seem counterintuitive – why would you want to pay more money at closing? However, mortgage points can actually save borrowers a lot of money over the life of their loan through lower monthly payments. 

In this article, we’ll break down everything you need to know about mortgage points, including how they work, their benefits and drawbacks, when you should consider paying them, and how to calculate if they make sense for your situation.

What Are Mortgage Points?

As mentioned above, mortgage points, or discount points, are fees paid to the lender to lower the interest rate on a mortgage. 

Each mortgage point equals 1% of the total loan amount. So if you take out a $300,000 mortgage, one point would equal $3,000. Mortgage points are paid at closing, and represent prepaid interest on the loan.

The more points you pay, the lower your interest rate will be. Typically, each mortgage point lowers the rate by 0.25%. On a $300,000 loan, paying one point would reduce the rate by 0.25%, while paying two points would reduce it by 0.50%, and so on.

How Do Mortgage Points Work?

Mortgage points work by allowing the borrower to prepay interest on their loan upfront in exchange for a lower interest rate. This reduced interest rate then results in lowered monthly mortgage payments over the life of the loan.

For example, on a $300,000 30-year fixed mortgage with a 5% interest rate, the principal and interest payment would be about $1,610 per month. If you pay one point upfront to lower the rate to 4.75%, your payment would decrease to around $1,549 per month. 

While you have to shell out more cash at closing by paying points, you benefit through lower monthly payments for the duration of your mortgage. This can lead to substantial interest savings over time, especially on a long-term mortgage.

How Are Mortgage Points Paid?

There are a few different ways borrowers can pay mortgage points:

1. Paying at Closing

The most common way to pay points is by including them in your upfront closing costs. The funds for the points will be due at closing along with your down payment and other fees.

2. Rolling Into the Loan Amount

Some lenders may allow you to finance the points by rolling them into the total loan amount. This avoids having to pay the points in cash at closing. However, it will increase your loan balance and monthly payments.

3. Seller-Paid Points

In certain cases, like a buyer’s market, the seller may agree to cover some or all of the mortgage points for you as part of the negotiation. This perk can save you thousands upfront.

According to Freddie Mac, the average number of mortgage points paid by borrowers in the United States in 2022 was 0.72.

Benefits of Paying for Mortgage Points

Why would anyone want to pay extra fees upfront when taking out a mortgage? Here are some of the biggest benefits of paying points:

1. Lower Interest Rate

The main incentive for paying points is to secure a lower interest rate on your mortgage. This reduced rate can shave hundreds of dollars off your monthly payment and tens of thousands in interest costs over the loan term.

2. Lower Monthly Payments

The lower interest rate also results in lowered monthly mortgage payments. This improved affordability and cash flow can be very valuable, especially for borrowers on a tight budget.

According to LendingTree, borrowers who pay mortgage points upfront can save an average of $300 per month on their mortgage payments.

3. Tax Deductions

In some cases, you may be able to deduct the cost of your points in the year they were paid, which provides some monetary relief. However, the deductibility depends on your financial situation.

Drawbacks of Paying for Mortgage Points

While points have benefits, there are also some potential drawbacks to consider:

1. High Upfront Cost

The main disadvantage of paying points is that it increases your upfront cash outlay at closing. Each point can equal thousands of dollars depending on your mortgage amount. This high one-time cost might not be feasible for some borrowers.

2. May Not Stay in Home Long Enough to Recoup the Cost

Since you have to pay points upfront, it takes time to recoup the costs through savings on your monthly payments. If you don’t stay in the home long enough, you might not reach the break-even point where paying the points pays off.

According to Bankrate, borrowers who plan to stay in their home for less than five years may not benefit from paying mortgage points upfront.

3. Could Use the Money for Other Purposes

Some people might be better off using the money set aside for points for other financial priorities like boosting their emergency fund, investing, or paying down higher interest debt. The upfront cash could potentially be put to better use elsewhere.

When Should You Buy Mortgage Points?

Given the pros and cons, here are some good scenarios when paying for mortgage points would likely make sense:

• You plan on staying in the home long-term, at least 5-7 years. This gives you time to recoup the upfront cost.
• You can comfortably afford to pay the points upfront without impacting other financial goals.
• You will benefit significantly from lowered monthly payments. For example, if you struggle with high housing costs. 
• You stand to save a lot over the loan term with a lower rate. This is common with larger loans or higher rates.
• You qualify for point deductions on your taxes.

According to Credit Karma, mortgage points are most beneficial for borrowers who plan to stay in their home for at least seven years.

When Should You Avoid Buying Mortgage Points?

On the other hand, here are some scenarios where you may want to think twice about paying for mortgage points:

• You anticipate moving before hitting the break-even timeframe.
• Paying points would severely deplete your available funds or emergency savings.
• You have an unstable income and uncertainty about the future.
• You can get a competitive rate from lenders without buying points. According to NerdWallet, borrowers with good credit scores and high down payments may be able to negotiate a lower interest rate without paying mortgage points upfront.
• You have other higher interest debts you could pay off or investments with higher returns.

What Is the Difference Between Discount Points and Origination Points?

There are two main types of points you’ll encounter:

• Discount points – These directly reduce the interest rate on your mortgage when paid upfront. They function as prepaid interest on the loan.
• Origination points – Origination points are lender fees that cover processing costs. They do not lower the interest rate.

Discount points provide financial benefits by reducing your rate, while origination points do not. Make sure to know what type of points you are paying and how they will or won’t impact your loan terms.

How to Calculate Whether Buying Mortgage Points Makes Sense

Determining if paying for mortgage points is financially prudent for you requires some financial analysis. Here are a few steps to take:

• Compare interest rates with and without points to see potential savings.
• Calculate your breakeven timeframe where paying points will pay off. Online mortgage calculators can be very helpful. 
• Factor in how long you plan to stay in the home and your budget.
• Be cautious of “teaser” below-market rates offered with excessive points.
• Consult with a loan officer or mortgage broker to run the numbers and assess scenarios. 

According to Zillow, the average borrower saves about $10,000 over the life of a 30-year mortgage by paying one point of interest upfront. However, the savings can vary significantly depending on the specific loan terms, so it’s critical to run the numbers for your situation.

Conclusion

Mortgage points can unlock savings by reducing interest rates for qualified borrowers who plan to stay in their home long enough to realize the benefits. However, points do come with upfront costs to consider carefully. 

When used strategically for the right home buyer, points can lower housing costs both today and well into the future through discounted interest rates. But their value depends heavily on personal factors like your down payment, budget, credit, loan amount, and how long you plan to stay in the home.