What are Mortgage Points?

Mortgage points are fees paid in conjunction with getting a mortgage loan. Each mortgage point is equal to one percent of the mortgage loan amount. As an example, if you take a mortgage loan of $250,000, one point would equal $2500.

Mortgage points can occur in two forms: origination points and discount points. In both cases, the definition of mortgage points applies – one point equals one percent of the loan amount.

Origination points

Origination points on a mortgage represent fees charged by the mortgage lender or broker for the services provided by that company. It used to be the standard in the mortgage industry that a lender or broker would charge a one-point origination fee.

Origination points are not as common as they used to be. That’s due to a change in the mortgage regulations that restricts mortgage companies from charging an origination fee and also receiving income based on the loan interest rate (known as a yield spread). The regulation requires mortgage companies to choose one income source or the other, but not both. Because mortgage companies typically need to earn more than one percent of the loan amount to be profitable, and because they don’t want to charge applicants multiple points at closing, they elect to receive their income entirely from yield spread. That means the traditional one-point origination fee appears less frequently than it used to.

Discount points

Discount points differ from origination points in that discount points are paid so that the homeowner/buyer gets a lower interest rate than they would otherwise receive. In essence, they are a form of prepaid interest. The rate improvement you could expect to receive by paying points on a mortgage is not consistent day-to-day or lender-to-lender, but as a rule of thumb, you could expect that each discount point should lower your mortgage interest rate by about 1/4 percentage point. If the standard, non-discounted rate is 5.00%, paying one discount point would likely improve your rate to 4.75% or so.

For the rest of this post, we’ll be talking about discount points specifically.

Should you pay discount points?

The decision whether or not to pay mortgage discount points boils down to whether it is better to pay a sizable fee up-front in exchange for a bit lower interest rate and lower monthly payment after closing. Here are the pros and cons of paying points.

The argument for paying mortgage points

If you choose to pay one or more mortgage points, your benefit is that you’ll lower your interest rate and monthly payment. For someone whose objective is to keep their mortgage payment as low as possible, deciding to pay points could help achieve that goal.

The arguments against paying mortgage points

Lower interest rates and mortgage payments are something everyone wants but paying points to achieve this may not be as beneficial as it first appears.

Costs versus interest rate and mortgage payments

Discount points, like all closing costs, are a trade-off for a lower interest rate. However, it’s unlikely for most people that the smaller monthly payment will offset the cost of discount points over the life of the loan. For that reason alone, we don’t recommend people pay discount points – or any closing costs – except in a couple of special situations outlined below. Here’s why.

Let’s stick with our $250,000 loan amount example. One discount point would cost $2500 and if that discount point resulted in a reduced interest rate of 1/4%, the homeowner would save about $38 per month. If you divide the $2500 discount fee by the $38 monthly savings, the break-even point occurs at 66 months. That means the homeowner would have to save that $38 for five-and-a-half years before recovering the $2500. Beyond that, there is an “opportunity cost” of using $2500 buying points instead of using those funds for some other useful purpose. Investing at a 5% after-tax gain would reduce the monthly savings to just $26 per month. That would stretch the break-even point out to about 8 years.

Wouldn’t paying points still make sense on a mortgage that has a 15, 20, or 30-year term? Not for most people. The important point to realize is that it’s exceedingly rare for a homeowner to keep a mortgage for the full duration of the loan term. The average time a homeowner holds a mortgage before refinancing, moving, or paying off the loan is under four years. Knowing that it doesn’t make sense to pay costs that will take five years or more to recover.

More cash is needed at closing

Another difficulty with choosing to pay discount points is that doing so means more money will be needed at closing, potentially a lot more. When buying a home, the down payment and other closing costs are usually the biggest hurdle to overcome. Increasing those costs by one or two percent of the loan amount can add thousands of dollars to the funds needed to close. This is true for both purchase and refinance transactions, the biggest difference being that on a refinance the costs are usually added to the new mortgage balance. That means the homeowner is forfeiting equity in their home and paying interest on that amount for the duration of the mortgage.

When does it make sense to pay mortgage points?

There are a couple of situations where it makes sense to pay mortgage points. The situations are related to each other in that both involve a third party paying the borrower’s closing costs.

Relocation

If you’re relocating and your employer is paying your mortgage closing costs as part of a relocation package, buying mortgage points may be a good option. Many employers will pay a specific amount toward an employee’s closing costs when that employee is being asked to move from the company. If the amount the employer will pay is more than the standard closing costs, that remainder can often be applied to discount points.

Seller paid closing costs

Similar to a relocation situation, if a home seller is willing to pay closing costs for a buyer, discount points could be a way to make sure no money is left on the table. Since seller contributions can usually only be applied to closing costs and prepaid items – and not to the down payment or home repairs – a home buyer can use discount points to make sure that the full amount of the seller paid closing costs is used and receive the benefit of a lower interest rate.

Get competent professional advice

Before you buy mortgage points, be sure to consult with a competent, honest mortgage loan officer like those working at Certified Home Loans. Our entire team is trained to review your entire situation and recommend only the solutions that achieve your objectives.