By MARCIE GEFFNER
Homebuyers tend to be laser-focused on getting the lowest possible interest rate for their mortgage. A low rate is desirable because the lower your interest rate, the lower your monthly payment.
But a low rate isn't the only thing you need to consider when you choose a mortgage.
Understanding the point of mortgage points
Mortgages typically involve a variety of fees. Some of those fees are known as "points" because they're based on a percentage, or point, of your loan amount. One point is equal to 1 percent of your home's mortgage amount. For example, a fee of one point for a $250,000 mortgage would cost $2,500, while a half-point would cost $1,250.
There are two kinds of points:
- Origination points.
- Discount points.
Origination points and discount points are "somewhat synonymous" because they're both fees based on a percentage of the loan amount, says Fred Arnold, branch manager at American Family Funding in Santa Clarita, California.
But there's an important difference: Origination points are simply fees to cover the cost of setting up the loan, while discount points lower your rate.
Lenders offer discount points so borrowers can "get a lower rate in exchange for paying a fee upfront," Arnold explains. Each point that you purchase will generally lower the interest rate on your mortgage by 0.25 percent.
Run a breakeven analysis.
With discount points, you pay some of the interest at closing instead of over the life of the loan. That's why discount points are sometimes called prepaid interest. The more interest you pay upfront in the form of discount points, the lower your rate will be.
Say a lender offers you a choice of two loans: Both mortgages are for $200,000 with a payback term of 30 years.
- Loan A has a fixed rate of 4.625 percent and no discount points. The monthly payment is about $1,028.
- Loan B has a fixed rate of 4.125 percent and two discount points. The monthly payment is about $969.
Loan B saves you around $59 each month, but you'd have to pay 2 percent -- or $4,000 -- of your loan amount upfront to get that lower rate and savings.
Should you pay $4,000 upfront to save $59 each month? The answer partly depends on how long you plan to keep your loan. The longer you keep it, the more time you'll have to save $59 each month and recoup the $4,000.
Along the way, you'll hit a breakeven point when you've saved enough to equal the initial outlay. In our example, the breakeven point is 68 months, or around five and a half years.
If you plan to stay in the home longer than that, it might make sense to pay those points upfront. If you kept the home until you paid off your loan in 30 years, you'd save around $21,000 in total interest.
Consider the tax-deduction possibilities.
Your decision may get more complicated if you know you'll want to itemize your deductions on your tax return. That's because both discount points and mortgage interest can be tax-deductible if your situation fits the applicable tax rules.
Paying discount points allows you to increase your tax deductions, which lowers how much tax you have to pay. But paying discount points also lowers your interest rate, which lowers your total monthly interest expense for the year, giving you a smaller interest deduction when it's time to file your taxes.
To fully understand how paying discount points could affect your personal income tax situation, you should ask your tax preparer for advice before you take out a mortgage.
Should you pay mortgage points?
Paying a point or two could make sense if you plan to keep your loan a long time, rather than refinance or sell your home after a few years.
There's always a little bit of guesswork involved in this decision because you'll never know for sure how long you'll keep your loan. You might intend to keep it 10, 20 or even 30 years, but you could end up refinancing or selling your home sooner.
Another consideration is how much cash you have. If you don't have enough money to pay points in addition to your down payment and other costs when you get your loan, you might want to avoid the extra expense.
Keep in mind that the rate isn't the only factor to consider when you get a mortgage. When shopping for a mortgage, consider not only the rate and the points you'll have to pay to get that rate, but also how long you'll stay in the home, your tax deductions and your overall financial situation.
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