In the United States, it is common practice to pay for mortgage points, which come in two varieties: origination points and discount points. Each is equal to 1% of the total loan amount. This means for a $100,000 home loan, one point is equal to $1,000.
Origination points are used to compensate mortgage loan officers, and these points are not tax deductible.
Discount points, on the other hand, are prepaid interest. Each point purchased lowers the interest rate on the mortgage by 0.25%. Most lenders allow borrowers to purchase zero to four discount points, which may be used to decrease mortgage payments. Discount points are tax deductible.
When lenders advertise mortgage rates, they typically show a rate based on the purchase of points. Discount points are paid at closing. Buyers may not pay points on a VA or FHA guaranteed home loan, but home sellers can.
This decision requires understanding the mortgage payment structure, as there are two very important considerations to keep in mind when deciding whether or not to pay for discount points.
The first factor is how long you expect to live in your home. The longer you stay in the home, the more you can save by purchasing points. For example, a $100,000 loan with a 6% interest rate will result in a principal and interest payment of $599.55 each month. With the purchase of three discount points ($3,000), the interest rate drops to 5.25% and the monthly payment is lowered to $552.20 each month.
To break even in this example, the homeowner would need to stay in the home for 63 months. Because a 30-year mortgage lasts for 360 months, purchasing points can result in substantial savings over the long run.
The second factor is whether or not you have the cash to pay for discount points. Many home buyers have trouble just affording the down payment and closing costs and do not have money left over to buy points.
Some experts argue that the money used on discount points could be put to better use by investing the money for a higher return. The average homeowner, however, is generally more concerned with getting into a mortgage they can afford, and this concern outweighs potential benefits that may be earned by choosing a different investment.
Homeowners also tend to buy a home not for increasing value but as a place to live and own in the long run. Even if your home triples in value, you will still be unlikely to sell because you will still need a place to live, and surrounding homes have also likely gained in value as well.
If you plan to remain in the home for many years and you want a lower monthly payment, buying discount points is worth the cost, as long as you can afford the upfront payment.