Laura answers a listener's question about whether buying mortgage points saves money over the long run.
Laura answers a listener's question about whether buying mortgage points saves money over the long run.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
Have a money question? Send an email to money@quickanddirtytips.com or leave a voicemail at 302-365-0308.
Find Money Girl on Facebook and Twitter, or subscribe to the newsletter for more personal finance tips.
Money Girl is a part of Quick and Dirty Tips.
Links:
https://www.quickanddirtytips.com/
https://www.quickanddirtytips.com/money-girl-newsletter
https://www.facebook.com/MoneyGirlQDT
https://twitter.com/LauraAdams
Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Jimmy, who says, "I'm buying my first home and researching mortgages. I see options that include points. Can you explain how to know if buying points will save me money in the long run?"
Thanks for your question, Jimmy! I recently bought a new home and also had to determine if buying points would benefit me. Don't miss this episode if you're in the market to buy a home or want to understand the pros and cons of mortgage points for a future transaction.
This post will review five things you should know about points so you can choose the best home loan for your situation.
Thanks for downloading episode 901 of the Money Girl podcast! I'm Laura Adams, an award-winning author, money speaker, on-camera spokesperson, and founder of The Money Stack, a free Substack newsletter.
You can learn more and connect with me at LauraDAdams.com. That's also where you can email your money question and sign up for The Money Stack, which gives subscribers a terrific Money Success Toolkit. You can also record a brief question or comment on our voicemail line at 302-364-0308.
5 things you should know about mortgage points
Getting a mortgage is a massive financial decision, and buying points can help you get the best deal–but they aren't for everyone. Here are five things you should know about mortgage points so you can evaluate if the expense will eventually pay off.
1. How mortgage points work.
Mortgage points, or discount points, are an upfront fee you pay to a lender to reduce the interest rate on a home loan. Buying points means you prepay interest in exchange for a lower interest rate, and is also known as “buying down” your rate.
Every mortgage point you buy reduces a loan's annual percentage rate (APR) by 0.25%. So, if the original APR is 6.5%, paying one mortgage point knocks it down to 6.25%. Paying two points reduces the rate to 6%, and so on. So, the more points you buy, the lower your interest rate.
For example, if you're shopping for a $300,000, 30-year, fixed-rate mortgage at 6.5%, your total interest paid over the life of the loan would be approximately $382,000. But if you bought three points, getting a 5.75% rate would mean paying about $330,000 in total interest. That's a massive interest savings of $52,000 over the life of the loan!
2. The cost of mortgage points.
One mortgage point typically costs 1% of your home loan amount. So, if you want to borrow $300,000 to buy a home, one mortgage point costs $3,000. You'd have to pay $6,000 for two and $9,000 in the previous example for three points, and so on.
Most homebuyers who opt for points buy between one and three and can also purchase fractions of points. Lenders typically cap the number of points you can buy to four, giving you a 1% maximum rate discount.
The challenge for buyers is that lenders usually require you to pay points upfront. So you must have enough savings, on top of your downpayment and additional closing costs, to pay points in cash at your home closing.
3. The benefits of buying mortgage points.
As I mentioned, paying a few thousand dollars upfront for one or more mortgage points could save you tens of thousands of dollars in interest over the long run. A lower interest rate on a fixed-rate mortgage means you pay a smaller monthly payment. Therefore, buying points can help you keep the monthly cost of a new home within your budget.
For example, if you get a $300,000, 30-year, fixed-rate mortgage at 6.5%, your monthly principal and interest payment would be about $1,900. But if you bought three points, discounting the rate to 5.75%, your monthly payment would be $1,750, saving about $150 a month or $1,800 a year.
In addition to paying less interest and lower monthly payments, mortgage points usually qualify as tax-deductible mortgage interest. If you itemize deductions on Schedule A, you can include a certain amount of mortgage interest, including prepaid points, to reduce your tax liability.
The IRS specifies that separate lender fees are not the same as mortgage interest or points. So, it doesn't qualify as a tax deduction if you buy mortgage points to reduce your origination fee instead of your interest rate. If you're unsure if your mortgage points are deductible, consult a qualified tax accountant.
4. The downsides of buying mortgage points.
Mortgage points have many benefits, but there are downsides to consider. As I mentioned, you must have enough savings to purchase points upfront. Our current housing market is already challenging enough for buyers due to high home prices and mortgage interest rates.
So, in addition to needing cash for a substantial downpayment and closing costs, points could stretch the average homebuyer's budget thin. Buying points isn't wise if you don't have enough to pay them and maintain a healthy cash reserve.
Don't forget that a mortgage payment has four components known as PITI: principal, interest, taxes, and insurance. Be sure you factor in typical homeowners insurance rates, property taxes, and any homeowners association dues to get an accurate picture of your potential total monthly housing obligation.
Another con for points is that if you don't own a home long enough, you won't break even on the cost. Let’s go back to my previous example where you get a $300,000, 30-year, fixed-rate mortgage. If you pay $3,000 for one point to discount the rate from 6.5% to 6.25%, your payment would decrease from $1,900 to $1,850, a $50 monthly savings.
To determine when you break-even on points, divide the cost of points by your monthly savings. That’s $3,000 divided by $50, which is 60 months, or five years. You might also have tax savings to include, depending on your situation.
So, you'd need to make payments for at least five years to save enough interest to recoup what you paid for points. If you sold the property before owning it for five years, you'd lose money on points.
In other words, if you're not sure how long you'll stay in your home or think there's a chance you may need to sell it before the break-even point, buying points won't save you money in the long run.
Another potential con for mortgage points is buying them before interest rates decrease. If rates substantially decline, you could refinance your mortgage for a lower rate without buying points. While no one can predict the future of interest rates, consider what's happening in the economy and ask professionals, like a real estate agent, mortgage broker, or a financial advisor for guidance.
Also, remember that every financial move comes with an opportunity cost for doing something else with your money. Let's say that paying $9,000 on points saves you $52,000 on mortgage interest over the life of a 30-year mortgage. What if you invested the $9,000 instead and let it grow for 30 years with an average 8% return? That would allow you to earn about $100,000, nearly double the mortgage interest savings.
5. How to decide if you should buy mortgage points.
While paying mortgage points can save money over the life of a loan, it isn't for every home buyer. To sum up, paying points may not make sense if:
When you shop for a mortgage, compare rates with multiple lenders. Ask them for quotes with and without points to make an apples-to-apples comparison and carefully crunch the numbers.
If you plan on staying in your home for the foreseeable future, can easily afford points, and don't believe interest rates will drop significantly, buying mortgage points can save you money.
Before we go, here's a quick reminder to subscribe to The Money Stack, my Substack newsletter, when you visit LauraDAdams.com. It's filled with money tips, tools, news, challenges, and things I enjoy! You can subscribe for free or become a paid member with access to live educational events.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, Davina Tomlin is our marketing and publicity associate, and Nathaniel Hoopes is our marketing contractor.