Regardless of whether you’ve ever bought a home, you’re likely well aware that the process involves closing costs – the fees, charges and taxes that buyers and sellers generally incur to complete the transaction, including the transfer of the property. When you apply for a home loan, your lender is required to provide a good faith estimate of your various closing costs within three days. In most cases, you’ll have the option to purchase mortgage points, also known as discount points, in exchange for a reduced interest rate on your loan.
Not only can purchasing points lower your monthly mortgage payments, but this practice of “buying down the rate” can also enable you to save substantial money over the course of the loan under certain circumstances. We’ve provided an overview of how discount points work, and how you can use them to your best advantage, below:
How much do mortgage points cost? One point is a fee equal to one percent of your loan. Another way to look at this is that you’ll pay $1,000 for every $100,000 of your loan. For instance, one mortgage point will cost you $5,000 on a $500,000 loan.
How much do discount points lower your loan? There is no standard interest rate reduction as this percentage will depend on the type of loan you take out, your lender and market fluctuations. However, a common rate reduction for one point might be one quarter of a percentage point for a fixed-rate loan or three-eighths of a percentage point on an adjustable-rate mortgage (ARM). For example, you might lower your interest rate from 4.50 percent to 4.25 percent by purchasing one point. In this same scenario, you might purchase three points to lower your interest rate to 3.75 percent.
When does buying points make sense for you as a homebuyer? You’ll generally come out ahead by buying points if you own your home for a longer period of time than it will take to recapture the upfront cost of buying them. Of course, this will vary depending on the loan, but it usually takes at least five years to reach a break-even point.
Another possible consideration is whether you’ll need to carry private mortgage insurance (PMI), which is designed to protect your lender. Private mortgage insurance is usually required for those who make a down payment of less than 20 percent of the home’s purchase price and take out a conventional loan. If you must decide between making a 20 percent down payment (thereby avoiding PMI) or purchasing points, you’ll want to ensure that the cost of private mortgage insurance won’t negate the value of buying points to save on interest.
Even if you aren’t required to make PMI payments, you’ll want to determine your break-even point so that you know how many months you’ll need to own your home to make purchasing points worthwhile.
How to calculate your break-even point: Take the cost of your points and divide this amount by how much you would save on your mortgage each month by purchasing points. The number you get will tell you how many months you will need to own the home in order to recoup the money you paid for your points. The key is to own the home for a longer period of time than it will take to reach this break-even point.
Are there any tax benefits for buying points? If you’re purchasing discount points for a home that will be your primary residence, you may indeed be able to use them to lower your federal tax bill since these points are essentially prepaid interest. For homes purchased after Dec. 14, 2017 and until 2026, this mortgage interest deduction caps out at $750,000 of mortgage debt. Also keep in mind that if you use points as a deduction, you’ll need to itemize them on Schedule A of IRS Form 1040 rather than taking the standard deduction, which goes up to $12,000 for individual filers and $24,000 for joint filers on income generated in 2018. As NerdWallet points out, it’s a good idea to ask your lender to provide an estimate of your mortgage costs if you buy points, and another estimate if you don’t. You can then take these estimates to your tax professional to determine how both options would impact your tax situation.
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