By Emily Starbuck Crone
When you take out a mortgage loan, you run into a lot of closing costs, and few are optional. Most lenders, however, will give you the option to buy mortgage discount points, which can lower your interest rate. You may also get the chance to receive a negative point credit, though this will raise your interest rate.
Here’s the lowdown on what mortgage points are, how they work and when you should and shouldn’t use them.
What are mortgage points?
A mortgage point can be either positive or negative, though positive points are much more common. Buying a positive, or discount, point or receiving a negative point changes your mortgage interest rate. Each kind of point costs 1% of your mortgage loan amount. For example, if you have a $100,000 mortgage, you’d pay $1,000 for one discount point.
How do discount points work?
A discount point is essentially prepaid interest: You pay an upfront fee to lower the interest rate on your mortgage. Because purchasing points lowers your interest rate, buying them is often known as “buying down the rate.”
Discount points may be tax-deductible if the purchase is for your primary residence. Before buying points, you should have your lender give you an estimate for both scenarios — your mortgage closing costs if you buy points and if you don’t — says Ann Thompson, a divisional sales executive at Bank of America. She recommends then taking these two estimates to your tax professional to learn if points are tax-deductible for you and how each option would affect your overall tax situation.
How do negative points work?
Negative points, sometimes called rebate points, are different: The lender offers to give you a credit by paying some of your fees in exchange for a higher interest rate.
This is sometimes called a no-cost mortgage. Negative points can be paid either to a broker as part of his or her compensation or to the borrower to cover closing costs. When a lender offers you negative points, it is effectively saying it’ll cover some of your mortgage fees and charge you a higher interest rate in return.
The credit from negative points cannot exceed the mortgage closing costs, and these points can’t be used as part of a down payment. Thompson says points can be used to cover some nonrecurring closing costs, such as bank and title fees, but they can’t cover recurring fees like interest or property tax.
Why would you willingly take a higher interest rate? If you’re short on money needed for closing costs, “you may want to pay a little bit more in interest over the life of the loan to have some of that covered,” Thompson says. Another reason might be if you want to hang onto some cash for improvements before you move in and can afford a higher monthly payment.
How much is a point worth?
There’s no set amount for how much a point will lower or increase your rate, Thompson says. It varies by the type of loan, the lender and prevailing rates, since mortgage rates fluctuate daily.
On the day of the interview with Thompson, June 5, buying a point on a fixed-rate loan lowered the rate by a quarter of a percentage point. On an adjustable-rate mortgage, the rate would drop three-eighths of a percentage point.
At Guaranteed Rate, a national lender, the savings are similar: Buying one point will typically lower your rate a quarter, or perhaps three-eighths, of a percentage point, says Dan Gjeldum, senior vice president of mortgage lending.
When should you buy points?
Deciding whether to buy mortgage discount points is always a case-by-case decision, though it typically comes down to two factors: time and money. How long will you stay in the house, and how much can you afford to pay to close your mortgage?
The key factor is how long you think you’ll stay in the home. Then you can calculate at what point you’ll break even on the cost of the points.
“I don’t personally ever encourage paying points simply because of the fact that it does take so long to make it up, especially for a first-time home buyer,” Gjeldum says. While it can make financial sense for some, first-time home buyers generally don’t hold the mortgage long enough to make up the upfront expense, he says.
That money may be better spent on improvements like paint, landscaping or new carpets, he adds.
It may make sense to buy points when you’re purchasing a long-term investment property or a home you plan to hold for many years, Thompson says, since you’ll reap savings after breaking even.
Here’s an example from Thompson to help demonstrate how long it can take to benefit from buying a point. Say you’re taking out a $400,000 loan. Since one point equals 1% of the loan, buying one discount point would cost you $4,000. So first, decide whether you can afford to pay that $4,000 on top of your existing closing costs.
Based on mortgage rates the day she was interviewed, Thompson said buying a point would save you roughly $57 a month on your mortgage bill. By dividing the cost of the point ($4,000) by the monthly cost ($57), you determine how many months it would take you to make up the cost of buying the point. In this example, it’s about 70 months, or almost six years.
That means if you planned to stay in the home for six years, you’d break even, and any longer than that, you’d save money. But if you moved out before then, you’d have lost money.
Gjeldum says buying points makes sense if the seller is willing to pay for it. Gjeldum and Thompson both say that if an employer is relocating you for work and offering to pay points to buy down your interest rate, it could also be worthwhile since you’re not the one shelling out money.
Emily Starbuck Crone is a staff writer at NerdWallet, a personal finance website. Email: email@example.com.