As a savvy consumer, you should always be looking for ways to shave some money from your monthly budget. Even small adjustments can add up to significant savings over the course of a year, a decade, and a lifetime. For most households, your mortgage will be the largest bill you have each month. Therefore, it is one of the best places for you to look to save money.
When you are planning to obtain a mortgage, either for a new home purchase or refinance, it pays to do your homework and get the mortgage that will cost you the least in the long run. You probably already know that you should get interest rate and closing cost quotes from multiple lenders and compare them to help you choose which lender to use. Another way you may be able to save money is by buying down your interest rate with points.
How buying down the interest rate with points works
Points, also known as discount points and loan origination fees, are a form of prepaid interest on a mortgage. One point costs you 1% of the loan balance, which you pay at the time of your settlement on the home. Each point buys down your interest rate by an amount determined by the lender, usually approximately 0.25%.
For example, say you were planning to purchase a home with a 30-year, fixed-rate mortgage of $150,000 at 4.5% interest. Your lender might tell you that you could purchase one point for $1,500 and buy down your interest rate to 4.25%. You would pay that $1,500 at closing, and the lender would base your monthly payment on the mortgage amount of $150,000 and interest rate of 4.25%.
You can purchase more than one point if you would like although the amount each point will buy down your interest rate may vary. Get a quote in writing from your lender as you are making your decision. If you cannot afford to pay the points out of pocket, you may want to consider writing an offer that includes the seller paying for one or more points. Motivated sellers are often willing to do this to help find a buyer for their home.
When is it a good idea to buy points?
Buying points can save you a lot of money, provided you keep the mortgage long enough. In the above example, your monthly mortgage payment would be $760 without buying any points, compared to $738 if you buy one point. This saves you $22 on your mortgage payment each month. However, remember that the point cost $1,500 upfront. Therefore, it would take 68 months or about five and a half years, to break even. If you plan to keep your mortgage at least that long, you will come out on top.
If you plan to itemize your deductions on your income tax return, you can typically deduct the cost of the points in the tax year you pay them because they are considered to be mortgage interest. This can reduce your taxable income for the year of your purchase and, in effect, partially pay you back for the money you spent on the points.
One interesting case in which buying points can help is if you are trying to buy a home that would require a mortgage slightly larger than the amount you qualify to borrow. Lenders limit your allowed monthly housing payment to 28 percent of your gross monthly income, and if your payment would be more, you may have a difficult time qualifying for a mortgage. However, if you have cash on hand to pay one or more points, you can buy down the interest rate to get your monthly payment within the necessary qualification limits.
When might you not want to buy points?
If you are not sure how long you will live in the house, or if you plan to move or refinance within the next five years, you should not buy points. In addition, if you are getting an adjustable-rate mortgage, you should not buy points because points do not affect the interest rate once it begins to adjust. Lastly, buying points is not a good idea if you do not have money to pay for them at closing and can't get the seller to cover the cost.