Understanding Mortgage Points
The interest rate on a mortgage is determined by the market, in combination with the borrower’s credit history and down payment. If a home buyer wants to save money on mortgage payments, one way to do so is by buying points at the closing.
SIRVA Mortgage works with home buyers every day, and we receive a lot of questions about mortgage points. Before closing on a house, you and your employees should understand what points are and how they work. Here’s what you need to know.
What Are Points?
Let's begin with an explanation of mortgage points. Simply stated, points are a way for a home buyer to trade up-front costs for a reduction in their interest rate and, subsequently, lower monthly payments.
|Purchasing mortgage points are a way for a home buyer to trade additional up-front costs for a reduction in their interest rate and monthly payments.|
A point may be referred to as a discount point, a mortgage pointor simply a point. However, some lenders use the term "origination point" to describe any upfront cost that is a percentage of the loan amount. An origination point does not reduce the interest rate. An origination point is a fee charged by lenders to cover some of the origination costs of providing the loan, for example, reviewing and processing the loan application.
One point equals 1% of the loan amount, so for a $300,000 mortgage loan, one point would cost the home buyer $3000. If a home buyer purchases points at the closing, they will receive a reduction in their interest rate, allowing them to save money in interest over the term of the loan.
What are the Benefits of Buying Points?
There are several benefits of purchasing points for the home buyer.
Trade Up-Front Expenses for Lower Monthly Payments
Buying points when closing on a mortgage adds to the up-front cost. The cost of points cannot be deferred, which means that the home buyer must pay for points at the time of closing.
While the up-front costs will be higher than they would be without points, the home buyer is trading the initial expenses for lower monthly payments. The lower monthly payments can translate into thousands of dollars in savings over the term of the mortgage loan.
Points May be Tax Deductible
Points are prepaid interest and may be deductible as home mortgage interest if deductions are itemised on Schedule A.
What are the Disadvantages of Paying Points?
While purchasing points has its advantages, there are also some disadvantages for home buyers.
Increased Closing Costs
The first disadvantage of purchasing points is directly related to one of the benefits. Because the home buyer is trading an up-front expense for long-term savings, more money is spent at the closing.
Considering that the closing cost of buying a house is usually between 3% and 6% of the purchase price, and that in most cases the home buyer is making a down payment as well, the up-front cost of buying a house is high even if points are purchased. The home buyer needs to be sure that they can afford the additional cost before they decide to buy points.
|The home buyer needs to be sure that they can afford the additional closing costs before they decide to buy points.|
Less Cash on Hand for Expenses
Because the home buyer will be paying more at the closing if they decide to buy points, they need to mindful that they are likely to have less cash on hand in the early days after buying the house. Owning a house comes with the responsibility of handling all repairs and maintenance costs, and the home buyer should make sure that they are prepared to pay these costs and still have emergency funds set aside.
How Much Will Buying Points Decrease the Interest Rate?
One of the most frequently asked questions is related to how much a buyer can save by purchasing mortgage discount points.
While the reduction in the interest rate may vary, the most common result is that each point bought will reduce the mortgage rate by 0.25%. If this is the case, a 6% interest rate with a single discount point would reduce the interest rate to 5.75%; two points would reduce the interest rate to 5.5%.
We should note that there are exceptions and variations from one mortgage lender to another, so the home buyer should be sure to ask their lender about how buying points will benefit them. The amounts may also be affected by the market.
The savings on the monthly mortgage payment can be calculated by comparing the payment without points to the payment with the lower interest rate with points applied.
To help illustrate how much the home buyer might save over the term of their loan, let's look at a quick example comparing a 6% rate with a 5.75% rate and a 5.5% rate. For this example, we’re assuming a $315,000 mortgage with a 30-year term.
|Interest Rate||Cost of Point(s)||Monthly Payment||Interest Paid in 10 Years||Interest Paid in 30 Years|
|5.75%||1 point: $3,150||$1,838.25||$167,419.01||$346,771.62|
|5.5%||2 points: $6,300||$1,788.54||$159,628.36||$328,872.73|
As you can see, even the purchase of a single point can lead to substantial savings over the term of the loan.
When Is It a Good Idea to Buy Points?
Is it a good idea to buy points from a mortgage lender? The answer is yes if the home buyer plans to stay in the house for a long time. The reason that longevity matters is because of the trade-off between up-front costs and long-term savings. If the home buyer only plans to stay in the house for a few years, or plans on refinancing within a few years, then they won't save enough to make the added expense worthwhile.
The way to know if the trade-off is worth making is to calculate the break-even point. That can be done by taking the total amount that would be paid for points and dividing it by the amount of the monthly savings. Let's use the numbers from the chart above as an example.
|If the home buyer plans to stay in the home for a long time, and they can afford the additional cost, buying points may be a good idea.|
With a $315,000 mortgage, the cost of a single point would be $3,150 and the monthly savings for a single point would total $50.33. When we divide $3,150 by $50.33, we can see that the break-even point happens at 63 months, which is just over five years. Therefore, if the home buyer plans on keeping this mortgage for at least 63 months, then purchasing points would make sense.
While everything can’t be predicted, if the home buyer’s intention is to live in the house and keep the same mortgage for a long time, and they can afford to do it, purchasing points is worthwhile.
When is it not a Good Idea to Purchase Points?
There are some scenarios when it doesn't make sense to add to closing costs by purchasing points. For example, the home buyer:
- Plans to stay in the home for only a few years. For example, young couples sometimes buy a starter home with the understanding that they'll move when they start a family. If the home buyer knows they won't be in the house for long enough to break even, it is not recommended to buy points.
- Plans to make extra mortgage payments. Buying points isn't the only way to reduce interest payments for a mortgage. A home buyer may prefer to have the flexibility of making extra payments when they can afford it instead of making an up-front payment.
- Needs the money for other things. If the home buyer has other expenses that require the use of their savings, then they are probably better off keeping their savings instead of buying points.
- Reduces their down payment. A down payment provides instant equity in the home, lowers the monthly payment, and may also lower the interest rate. The home buyer is better off making a bigger down payment than buying points.
- Believes interest rates will drop in the future. A rate drop may allow the home buyer to reduce their mortgage payments through refinancing their home. If the home buyer believes this will occur prior to the payback period then they should skip the points.
If any of these scenarios apply, the home buyer’s best bet is to take the interest rate that's offered without points instead of buying points. Remember, there is always the option of making extra payments if the home buyer can afford it to reduce the amount of interest paid over the term of the mortgage.
Should Employers Cover Points for Transferring Employees?
In today’s increasing mortgage rate environment, employers may consider paying for points for their transferring employees. There are some factors to consider when deciding whether to cover the cost of points for transferring employees.
If the transferee has a lower rate on their current home than what is available in the market today, they may be reluctant to move because they will lose their low interest rate. During the past two years, interest rates hit record lows due to actions the US Federal Reserve took to combat the economic impact of the COVID-19 pandemic. However, today’s interest rates are still considered to be historically low.
Interest rates fluctuate with the market. When rates go down the transferee may have the opportunity to refinance into a lower rate. As previously noted, paying points is not always worth the cost. Remember that one point typically reduces the interest rate by.25%. Money spent on points may be better spent on another benefit in your relocation programme. Including points in your relocation policy can also become an administrative burden. If points are covered in the relocation policy and interest rates go down, the policy language will need to be revised to remove the benefit.
Buying points isn't for everyone. But, if the home buyer can afford to add to their up-front expenses when buying a house, and they plan to stay in the home long enough to make the cost of points worthwhile, it may be worth considering purchasing one or more points at the closing.
Discussing options with the mortgage consultant is a great way to confirm the home buyer is making the right decision. When comparing offers from different lenders, home buyers should enquire if the rate includes points and make sure they are asking each lender to include the same number of points.
Whatever the financing needs of your transferees may be, SIRVA Mortgage is here to help. With 30 years of focus and expertise in relocation mortgage lending, we understand the important role home financing plays in the relocation process. Please visit our mortgage website to learn more, or contact us, at MortgageClientServices@sirva.com.
Contributor: Kathie Janowich, Director Loan Production, SIRVA Mortgage and Linda Laramy, Director Client Services, SIRVA Mortgage