For a lot of people, it’s hard to be excited about owning a home because of the cost of mortgages, closing costs, and other fees that you’ll now be responsible for. However, there are some ways to alleviate the burden.
Mortgage points, also known as discount points, are one example of how you can save on your mortgage payments and start to enjoy the more important aspects of owning a brand new home.
Let’s take a look at everything you need to know, including how they work and if they’re the right move for you.
What is “A Point” and How Does It Work?
While it might sound like a mortgage point is something you’d win in a game, no one here is keeping score. Instead, mortgage points are fees that you can pay directly to a lender in exchange for a reduced interest rate. Sometimes, you may hear someone refer to this as “buying down the rate.”
Essentially, you’ll be paying a portion of the interest upfront to make lower interest payments throughout the loan. Typically, one mortgage point equals 1% of the total mortgage amount. You can buy multiple points or even fractions of points.
How Do Mortgage Points Work?
The concept of paying more money upfront might seem counterintuitive, but let’s look at an example to understand better how these might be beneficial.
Let’s say you’re taking out a $100,000 mortgage. For a 30-year loan at 3.5% APR, you’d be making monthly payments of $449 every month. But let’s say you have some disposable income upfront, and you’re able to buy some mortgage points.
At 1% of the mortgage price, you can purchase a single point upfront for $1,000. If you were to buy four points for $4,000, you’re now only paying off $96,000 throughout the loan, leading to lower interest rates from the start. That means you’re only paying $431 each month.
Of course, it will take several months before you “break-even” and the interest you’ve saved compensates for the initial cash investment. By dividing your upfront mortgage point costs by your monthly payment savings, you can figure this out.
So in the example above, you’d take $4,000 divided by $18, which means it would take 222 months (18.5 years) before you break even.
As you can see, that’s a long period, so the upfront costs might not be worth it for every single situation. Let’s look at when it might make sense to purchase mortgage points.
Mortgage Points vs. Down Payments
Mortgage points are an upfront cost that you’ll pay before you close. However, this differs from making a down payment.
Down payments are a necessary payment that you’ll need to make before closing to give the lender a “safety net” if you default on the loan. While FHA loans allow you to make a down payment of as little as 3.5% upfront, it’s recommended that you make a 20% down payment of the total mortgage cost to avoid paying [private mortgage insurance](https://www.consumerfinance.gov/ask-cfpb/what-is-private-mortgage-insurance-en-122/) or PMI.
Private mortgage insurance is a monthly fee that usually amounts to .58% to 1.86% of your original loan amount. It can be pricey and frustrating. With that in mind, you typically want to choose a higher down payment instead of paying for mortgage points if it comes down to it.
This is because the savings of not having to pay PMI is likely to be higher than what you’d save from mortgage points.
Extend Your Loan Term
Many people like to choose [15-year mortgages](https://www.networkcapital.com/blog/refinancing-to-a-15-year-mortgage-the-pros-and-a-few-cons) because the thought of being out of debt sooner is more appealing. While it’s a great feeling to be debt free, monthly payments will be higher the shorter the loan term is.
With that in mind, thoughtfully take a look at your budget and consider extending the length of your term to diminish those monthly payments. For instance, your monthly payments on a $100,000 mortgage at 3.5% APR is $449 for a 30 year mortgage, but it’s $715 for a 15 year mortgage.
With that said, since you’re paying off your principal balance sooner with a shorter term, you’ll save more money overall. But it sometimes makes more sense to alleviate the initial financial burden by extending the length and making smaller payments. You can always refinance down the line to a shorter loan term to pay off your debt quicker.