How Mortgage Points Lower Your Interest Rate
Mortgage points can decrease your interest rate if you pay extra upfront in closing costs.
Jan. 15 2021, Published 1:48 p.m. ET
In the mortgage world, points can also be called discount points, and they refer to when a buyer pays more upfront in closing costs. In exchange for the additional payment, the borrower gets a lower interest rate over the life of the loan.
As a borrower, you have a choice to pay more upfront to save money later. If you pay less upfront, your monthly payment will be higher. If you don’t have a lot of extra cash on hand, it makes sense to take the higher interest rate. Calculate your mortgage payments using various scenarios to choose the best mortgage options for you.
Why mortgage points are important
By paying for mortgage points when you first take out a home loan, you receive a lower interest rate, which decreases your monthly payments. There are other factors that determine your mortgage interest rate, but paying for points will result in a lower rate.
The reverse of mortgage points is “lender credits,” which means paying less in closing in exchange for a higher interest rate.
How mortgage points work
Simply put, mortgage points are calculated as a percentage of the loan amount. Each point you buy equals 1 percent of the total loan amount.
For example, on a $200,000 loan, you can buy 1 point for $2,000, or 1 percent of the total amount. Points don’t have to be round numbers. A borrower can get half a point, which would be $1,000 on a $200,000 loan.
While the value of 1 point is set at 1 percent of the loan, the interest rate reduction isn't an exact formula. The interest rate depends on your lender, loan type, and other mortgage market factors. However, the general rule is that by paying for points, you receive a lower interest rate, often 0.25 percent per point, according to Bankrate.
Buying points on a mortgage is a tradeoff
As a homebuyer, you can think of points as a tradeoff. Either you pay more now and get a lower payment for the entire loan or pay less now and pay slightly more monthly for the life of the loan. Buying points is essentially prepaying the interest.
Mortgage points aren't bad for a homebuyer
Mortgage points are good for a homebuyer, but only if you can afford to pay more upfront for closing. You should also consider how long you plan to keep the loan. If you plan to stay in the home for many years, the interest saved should make it worthwhile.
Buying points versus putting more money down
Buying points is usually a good choice if you can afford to pay extra at closing and you plan to stay in the home for a long time. Selling after only a few years might mean that you lose out on the prepaid interest.
However, many homebuyers already struggle with high upfront costs, so buying points isn't necessary. If it’s hard for you to pay extra for points, you are better off diverting as much money as you can to your down payment. A larger down payment also reduces the interest rates by lowering your loan-to-value ratio.
