Mortgage Points: How They Work And When To Pay Them

Among the many terms you hear thrown around during the mortgage process, just one is “mortgage points.”

Lenders will often mention these points, but rarely do they actually mention what they are — and how much they’ll cost you.

That’s at least partially because points are typically included with total closing costs (aka, all those costs you pay before anyone will hand the keys over). After all, borrowers are often more concerned with the bottom line than they are with specific details.

But since points are typically the largest of the closing costs charged, they definitely rate a dedicated discussion.

What are mortgage points?

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Mortgage points, or discount points, are fees that you pay to the lender upfront for discounted interest rates.

Generally speaking, one point costs about 1% of your mortgage loan amount.

For example: if you have to pay one point on a $200,000 mortgage, you will owe $2,000.

Over time, mortgage points can save you a bunch of money on interest payments! So, you will want to pay attention.

First, it is important to understand that there are two different types of mortgage points.

1. Origination points (or origination fees)

When you get a mortgage, you will have to pay “closing costs” to your lender or other third parties. Closing costs are a combination of one-time fees required to get a mortgage.

One of these costs is, you guessed it, origination points.

Origination points (commonly referred to as origination fees) are purely a fee charged by the lender in exchange for extending you a loan. That is, they don’t provide any type of benefit to you apart from enabling you to get the loan.

The origination fee is typically 1% of the loan amount. But lenders may charge a reduced fee in a very competitive mortgage environment, or even no fee at all.

Read more: What Should You Expect When Closing On A House

2. Discount points

Discount points are paid upfront and help to reduce the interest rate owed on your mortgage.

So, you’ll pay a certain number of points in exchange for a lower interest rate.

Discount points are not mandatory fees, but one you may choose to pay if you prefer a lower interest rate and payment. 

As attractive as that arrangement sounds, it’s not necessarily a slam dunk. The cost of the discount points, and the extra burden it may put on you at the closing table, may outweigh the benefit of the lower monthly payment.

Are discount points worth the upfront cost?

If discount points are an option with your mortgage, and they usually are, ask your mortgage representative to provide you with scenarios of your monthly payment without paying discount points, and then with paying discount points at different levels (like one point, two points, three points, etc.).

Only when you see the numbers with your own mortgage will you be able to make a clear decision.

An example of using mortgage points

To show how mortgage discount points work, the table below reflects a 30-year fixed-rate mortgage for $300,000. The second column shows the results without discount points being paid and the third shows the same mortgage with discount points paid.

The example in the table above assumes the discount points were paid either by the seller or by a gift from a family member. But even if the borrower paid the closing costs out of their own funds, the savings from discount points would be $19,440 ($28,440, less the $9,000 paid for the discount points).

Read more: Best Mortgage Rates

Who pays for mortgage points?

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Mortgage points – origination or discount – can be paid by any one of four different parties or a combination of two or more. Possibilities include you, as the borrower, the property seller, the lender, or by a gift from a family member.

1. You pay the points out of your own funds

This is a common outcome in strong real estate markets and among higher-priced properties. Sellers rarely pay any closing costs under either condition. If so, you’ll need to budget additional funds for closing.

Lenders will generally accept funds coming from any source, with the lone exception of borrowing. For example, lenders generally won’t permit you to take an advance on your credit card to pay the points.

2. The seller pays the points

This practice is more common in slower housing markets, and with lower-priced properties.

The sellers may offer to pay some, or all, of your closing costs, including points, to entice you to purchase their home.

But what the seller can pay differs based on the type of loan you have.

• For a conventional mortgage, the seller can pay up to 3% of the purchase price toward your closing costs if the down payment is less than 10%, 6% if it’s 10% or more, and 9% if it’s at least 25%.
• For FHA loans, the seller can pay up to 6% of the sales price, regardless of the down payment made.

You should be aware, however, that while sellers may willingly pay a 1% origination point, they may be highly reluctant to pay discount points. That’s because discount points are more about providing you with a lower interest rate and payment than they are about directly facilitating the sale of the property.

Also, sometimes the property seller is a builder. As the seller, the builder can cover the buyer’s closing costs within the same limits listed above.

3. Lender-paid points

This is actually a bit of a misnomer since the lender doesn’t actually pay the points for the borrower. Instead, they use what’s known as premium pricing.

The lender increases the interest rate in exchange for paying part of all the closing costs. (That’s where the word “premium” enters the picture).

Let’s say you’re taking out a 30-year mortgage for $200,000 with $4,000 in closing costs, which also includes a 1% origination fee.

To eliminate the closing costs completely, the lender will need to increase the interest rate on the loan from, say, 2.250%, all the way up to 2.750%. That’s a steep 0.500% increase in the rate, and we haven’t even included discount points.

While this is a fairly common arrangement to cover closing costs, including a 1% origination point, it makes little sense when it comes to discount points. That’s because premium pricing increases the interest rate that discount points are designed to lower. One cancels out the other, and there is no benefit to the borrower.

4. A gift from a family member

For borrowers who are short of cash beyond the down payment, and where the seller is unwilling to pay closing costs, those costs can instead be paid by a gift from a family member.

In fact, the family member can make a gift specifically to cover discount points to lower the interest rate on the loan. This can be done even if the seller pays other closing costs, or if the lender uses premium pricing.

If a gift from a family member is used, the lender will want the family member to execute a gift letter spelling out the amount of the gift, the source of funds, and when it will be paid.

It’s also likely they’ll want to verify the source of funds, with a copy of a bank statement or a direct account verification from the bank itself.

The “recovery period” of paying mortgage points

In the above example, we determined that by paying $9,000 in points upfront on your mortgage, you can save at least $19,440 over the life of the loan (and as much as $28,440 if the discount points are paid by either the seller or by a gift from a family member).

That sounds like a reasonably good deal on the surface.

But how many years will it take to actually come out ahead? In other words, how long will it take you to recover the cost of the discount points paid on the mortgage?

This is what’s known as the recovery period on discount points. It applies whether you are purchasing a home or refinancing an existing loan.

Read more: Will I Save Money By Refinancing My Mortgage?

How to calculate your recovery period

To calculate this, take the amount you would pay in mortgage discount points and divide it by the resulting monthly savings.

If the discount points cost $9,000, and you will save $79 per month, the recovery calculation will look like this:

$9,000  / $79 per month = 114 months

That means it will take 9.5 years for you to recover the $9,000 you paid upfront. Only after 9.5 years will your extra payment start saving you money.

Who are discount points best for?

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Unfortunately, there’s no easy answer when it comes to the question of discount points. They’ll work for some, but not for others. It will all depend on the specifics of the loan you’re taking, and your personal circumstances.

Those who don’t plan on owning the home longer than the recovery period

The takeaway from the example above is that if you expect to be in the home less than 9.5 years, paying discount points to lower the rate won’t make financial sense.

At least that’s the case if you will need to pay the discount points yourself. If they’ll be paid by the seller or by a gift from a family member, taking the discount will absolutely be worth doing.

Otherwise, it will only make sense if you expect to be in the home for longer than the recovery period.

The downside of paying mortgage points

Paying mortgage discount points is not the best use of your money.

Here are some reasons why:

• You may not have the mortgage for 11.5 years. Most people either refinance their mortgage or move to a new home within that timeframe. If you do either before you reach the 11.5-year mark, you will have lost money by paying the discount points.
• If money will be tight when you purchase the home. Paying discount points may be a needless extravagance (unless of course, the seller will be paying the points).
• If the seller is paying the discount points but insists that the final sales price be adjusted upward to compensate for the cost of the points, you will be trading a higher sales price and mortgage for a lower interest rate. Don’t fall for this offer — it’s a bad deal for you.
• Paying discount points out of your own pocket can leave you with less cash after closing — cash you’ll probably need as you prepare to move into your new home.

Are mortgage points tax deductible?

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Let’s get the easy part of this question out of the way first: origination points are not tax-deductible.

However, since they actually represent prepaid interest, discount points are tax-deductible.

They can be deducted in the year taken, but the IRS has a list of nine conditions that largely eliminate that option. The main culprit being that discount points must be a typical charge in your market area. That’s almost certainly not true, since they are an optional charge paid at the discretion of the borrower.

In most cases, discount points will be deductible over the life of the loan. That’s because the benefits they provide apply over the entire loan term.

How much of my discount points are tax-deductible?

You don’t need to calculate how much of the discount points paid will be tax-deductible – the lender will do that for you.

Each year you’ll receive IRS Form 1098 from the lender. It will report the interest you pay on the loan during the course of the year. Discount point interest credited to that year will appear in Box 6 of the form.

Are there any limitations to the tax-deductibility of discount points?

There is, however, an important limitation to the tax-deductibility of discount points, and mortgage interest in general.

The combination of low interest rates and higher standard deductions has reduced the number of taxpayers eligible to itemize their deductions.

For that reason, and because discount points are amortized over the life of the loan, discount points should never be seen as a viable tax reduction strategy.

Summary

For most people, in most home-buying situations, paying mortgage points is not worth the money.

Unless the seller is covering the mortgage points, it’s generally worth leaving those discount offers alone.

Read more:

• How To Get Approved For Your First Mortgage
• How Much Does A 1% Difference In Your Mortgage Rate Matter?