The Point of Points
What are these and why do I need them?
Points are one type of fee paid at closing by you to your mortgage lender. There are two types of points: origination and discount points. Origination points are charged to recover some costs of the loan origination process. Depending on the lender, the origination point(s) may be negotiable in whole or in part. Discount points are used to “buy” you a lower interest rate. This is known as a rate “buy down.”
Each point equals 1% of your loan amount. For example, 1 point on a $200,000 loan would cost $2,000. A general rule of thumb is that one full discount point will lower your fixed interest rate .250% or your adjustable rate .375%. These points lower the interest rate for the entire term of the loan.
Discount point(s) that you pay may be tax deductible. You should consult with your tax advisor to confirm whether discount points or origination points are tax deductible. For new purchases, the cost of points paid and your mortgage interest are tax deductible up front. However, in the case of refinances, points are not deductible. Instead, the deductions are spread out over the term of the loan (unless the entire loan is paid off early), making points more costly in comparison. There is an exemption if savings from the refinance were used to improve the home.
There’s a lot to consider when it comes to points and whether or not they are a worthwhile investment. How long do you intend to stay in the home? If your move is short-term, paying extra up front to get a better rate may not be in your best interest. For example, let’s say your mortgage is $200,000 plus a single point, or $2,000 in up-front costs. Now, assume that this lower rate saves you $50 a month. It will take you 40 months to recoup the initial cost of that point. Should you sell or refinance before the 40th month, you’ve lost that money and the opportunity cost of not having invested it elsewhere.
Keep in mind, interest rates are cyclical. When they are at historical lows and you plan to stay in a mortgage for an extended period of time, it makes sense to pay points. Conversely, if rates are high, it may not make sense to pay points but rather wait for rates to drop and refinance.
Why do some lenders charge points but others don’t?
It is up to the individual lender whether or not they charge origination point(s). Almost every lender’s pricing includes different levels of discount points. They may offer options with no points, 1-point, 2-points and maybe more. The more points that you are willing to pay, the lower the interest rate the lender will offer you. It is common for each option to include fractions of points (for example, 1.25 points).
When comparison-shopping, make sure that you know all the fees that are being charged. A lender offering 7% + 1 discount point but 0 origination points may be a better deal than the lender offering the same rate with 0 discount points but 1.5 origination points. Both types of points are calculated using the same formula. Before making a final decision, look over all details of the offer, not just the interest rate.
If you or someone you know would like to learn more about points, please give us a call at Embrace Home Loans.