Mortgage Origination & Discount Points: Understanding the Basics
05/15/2017 Kristin Demshki
POINTS BUYING A HOME LOAN TYPES
If you’ve been shopping around for mortgage lenders, you’ve probably heard a lot about mortgage points. But what are they and how do they affect your monthly mortgage payment?
What Are Mortgage Points?
A mortgage point is a percentage-based fee paid at closing. Each point is equivalent to 1 percent of your total loan amount. For example, on a $100,000 mortgage, one point would cost you $1,000. There are two types of mortgage points to consider: origination points and discount points.
Origination points cover the costs incurred by lenders for providing your home loan. A discount point is essentially prepaid interest, and is also known as “buying down the rate” on a mortgage. Buying discount points can help you lower your monthly mortgage payment.
Keep in mind that mortgage points are paid in addition to your down payment and closing fees. Understanding the purpose behind each of these points — especially when it results in savings — can help you decide whether paying these fees is worth the extra upfront costs.
Mortgage Origination Points
Origination points are fees which may or may not be charged by your particular mortgage lender. They can be a percentage of the loan amount or come in the form of a flat fee. As mentioned, these costs are used to pay the lender for processing, underwriting, and approving your home loan application.
These rates are not standardized and vary widely by lender, so you may be able to negotiate the number of origination points assessed on your mortgage to help lower the overall fees.
Understanding Mortgage Discount Points
Discount points can be purchased at the time of the closing to lower the initial interest rate on a home loan. While there is some variation between different loan products, most lenders will allow borrowers to buy down their rate.
For example, if you have a 4% interest rate on a $200,000 mortgage, your monthly mortgage payment would cost roughly $955 per month. If you buy one mortgage discount point — or pay $2,000 upfront — your interest rate may drop to 3.75%, lowering your monthly payment by roughly $29 per month.
Alternatively, borrowers can take advantage of rebate points, sometimes referred to as negative points, to lower their closing costs. Note that this will result in a higher interest rate.
Just remember, the associated interest rate discounts will vary depending on the real estate market and your mortgage company, so be sure to discuss your lender’s point practices before you decide to purchase any points.
Assume you have a 30-year fixed rate mortgage in the amount of $200,000 that includes total fees and costs of $4,000. To determine your total amount due at closing, your rebate or discount points are added or subtracted from your total fees and costs.
Scenario Interest Rate Points Amt. Due at Closing Est. Monthly Payment* Rebate Points 4.25% -1 $2,000 $984 Par (No Points) 4.00% 0 $4,000 $955 Discount Points 3.75% 0 $6,000 $926
As you can see, by choosing to opt for rebate points with the higher interest rate, you will save money at closing, but pay a higher monthly estimated payment. Conversely, choosing to opt for discount points with the lower interest rate, you will pay more at closing, but pay a lower monthly estimate payment.*Payment amount includes only principal and interest.
Tax Benefits and Guidelines for Mortgage Points
One of the advantages of discount points is that this prepaid interest may be deducted from your taxes — as long as you itemize your tax return.* These points may be deducted fully or over the life of your loan, though most homeowners must amortize their deductions over the loan term.
To determine your eligibility for a full deduction in the year of payment, as well as a greater tax break, consider the IRS criteria:
- The loan must be secured on your primary residence.
- Paying discount points is an established business practice in your region.
- The discount points align with what is typically charged in your area.
- You record income in the year you received the discount points, and deduct expenses in the year you paid them.
- The discount points are not paid in exchange for appraisal fee, title fee, attorney fees or property taxes.
- At closing, the funds you submit, plus any discount points the seller pays, must be at least as much as the discount points charged. In addition, you can’t borrow any of the settlement money from your lender.
- The loan must be used to purchase or build a primary home.
- The discount points are calculated as a percentage of your mortgage’s principal amount.
- The amount is clearly shown on the Closing Disclosure as discount points charged for your mortgage.
Of course the guidelines for these tax benefits can get a bit complicated, so make sure to consult your accountant or other tax advisor before filing your return.
*Consult a tax adviser for further information regarding the deductibility of interest and charges.
Mortgage Points ROI
When you’re deciding whether mortgage points are worth the costs, you should take two factors into strong consideration:
- The length of time that you plan to stay in your home.
- Your “break-even” point, where you see your Return On Investment (ROI) and recoup the additional upfront costs.
For instance, if you pay one discount point, or $2,000, to lower your interest rate (resulting in a monthly savings of approximately $29), it will take 69 months to break even. In a 30-year fixed-rate mortgage the loan term is 360 months, so purchasing these points may make sense. If you’re planning on staying in your new home for only a few years — not so much. Consider the length of time you’re planning on staying in the home when deciding whether or not paying discount points is right for you.
You can use our mortgage calculator to help estimate your payments.
In some cases, your home builder or the home seller may cover the costs of mortgage points on your behalf. However if you’re looking to purchase your home with the lowest out-of-pocket costs, you should consider an interest rate that provides you with rebate points.
Should You Pay For Mortgage Points?
While mortgage points can provide a way to pay off closing costs, or reduce your interest rates, they may not be right for everyone. Before you commit to paying for origination or discount points, ask yourself the following questions:
- Can I afford to purchase points in addition to my down payment and closing costs?
- How long do I plan on staying in my home?
- Am I choosing a fixed-rate or adjustable rate mortgage?
- Will I reap any tax benefits after buying mortgage points?
- Are the long-term savings worth the initial investment?
These questions will help you better determine if paying more fees upfront is the right choice for your unique situation. If you still have questions, talk to your lender to learn more about their mortgage points program — and whether buying points makes sense for you.
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