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Understanding Points in Home Mortgages

Understanding Points in Home Mortgages

If you are in the market for a mortgage to buy a house you've no doubt heard the term "points" being thrown about.  No, they aren't talking about the score from last night's NFL game; they are actually talking about a fee that is paid to the lender of the mortgage you are taking out to buy your home.  Points can have impact on your mortgage, both positive and negative, so being informed about how they can help and hurt you is crucial when determining if a mortgage loan is the right fit for you.

In the simplest form, points are a onetime fee that is paid to a lender and are used to secure a loan below the current market interest rate.  Each point represents 1% of the mortgage amount.  So if you have a mortgage for $150,000 then one point would be equal to $1,500.  A seller would pay points on a loan to reduce the interest rate of the loan which could potentially save them much more than the points cost up front over the life of the loan.
 Points are not always paid for by the buyer; they can sometimes be paid by the seller as well.  A seller would typically pay for points when they are in a rush to sell the property or have been having a hard time finding buyers for the property.  In this case it is used as an incentive to get the buyer to move on the property.

There are times when it may not be in your best interest to purchase points.  A rather simple way of doing this is to determine the payback period, or length of time it takes you to pay back the points you purchased up front.  First, determine your monthly payment amount without points, and then with points.  If you are paying $900 without points and $800 with points, your monthly savings is $100.  Now take the total cost of the points, say 2 points on a $150,000 mortgage which would be $3,000, and divide the cost by the monthly savings.  $3000/100 = 30 months.  It will take you 30 months to realize your savings of $100 per month.  For a 30 year loan, it would make a lot of financial sense to purchase the 2 points up front if you can afford them. 

Where you have to be careful with points is when you don't plan to be in your current home long enough to reach the payoff.  You also have to keep in mind that the cost for points is above and beyond your down payment on the house you want to purchase as well.  It can add significant up-front costs, which is why it is a wise move only if you plan on occupying the house for a long period of time and have significant cash up front to be able to afford it.

One final note about points - they are tax deductible as they are considered prepaid interest.  They are deductible by the buyer, even if the seller pays for them.  Points are deductible fully in the year they are paid for a new purchase, and over the life of a loan for a refinance.