Homebuyers looking to finance the purchase of a home with a mortgage have no doubt run into the term, "points." Just what are points, what do they do and how can they help? Read on for more information.
Discount points are fees/pre-paid interest paid to a lender at closing to buy down the interest rate on a mortgage for a home for a certain amount -- the more points you pay, the lower your interest rate. Each point will cost you 1 percent of the loan amount and may be able to lower your interest rate by at least .25% (one quarter of a percentage point). So, if you are borrowing $100,000, a point will cost you $1,000. If you are borrowing $300,000, a point will cost you $3,000.
The other kind of "points" are "origination points" that lenders will charge you to cover the costs of the loan. When a borrower considers purchasing additional points, they are discount points -- the ones that can buy down an interest rate.
If you expect to stay in a home for a long period of time (e.g., at least three to five years), discount points will save you money in the long run, since they reduce your interest rate and lower your monthly payment for the life of the loan.
Paying a little more for your loan at closing in discount points will help lower your monthly mortgage payments. For example, if you have a $300,000 mortgage for 30 years at a 6% fixed rate, your monthly payment would be just under $1,799. But if you purchased one point (at a cost of $3,000), you may be able to lower your interest rate to 5.75%, meaning a monthly payment of about $1,751 -- a savings of $48 a month. It varies how much a lender will reduce an interest rate for a point. (E.g., from one-eighth to one-quarter of a percentage point.)
Discount points are deductible from your taxes and you can get them deducted in the same year as your home purchase. (They usually are deducted under Schedule "A" of your IRS 1040 tax return.)
You will need more cash at closing to purchase your home. If you need to keep your closing costs as low as possible, you may want to consider not purchasing additional points.
You must stay in the home for a number of years before the points pay for themselves. For that $300,000 loan we talked about above, it would take nearly 63 months (or more than five years) to earn back the $3,000 you paid in points. So if you were to move before the five years, you would have wasted your money on the points.