The Pros and Cons of Buying Mortgage Points

There is a lot involved in the homebuying process, from finding the right real estate agent to determining the proper negotiation tactics for the real estate market in your area—and then there’s your mortgage. American Home Shield® is here to help you navigate the ins and outs of mortgage points by explaining what they are, what they’re worth, and how to know if buying them is right for you. Read on for mortgage points explained.

What are points on a mortgage?

You may be wondering: what is a mortgage point? Well, if you’ve ever heard the phrase “buying down the rate,” you might have some idea about what mortgage points are. 

There are two main types of mortgage points: origination points and discount points.

Mortgage origination Points

• Mortgage origination points are paid to the loan officer for the actual loan creation. Origination points have become less prominent than discount points, but some lenders still include them in their loan closing processes. 

Mortgage Discount Points

• Discount points on a mortgage, the most common type, are payments made by a homebuyer directly to a lender—most often a bank—in exchange for a reduced interest rate. This means that the homeowner pays up-front interest to have a reduced interest rate while paying off the remainder of the loan. You can think of discount points as prepaid interest: The more discount points you buy, the lower your interest rate. Lenders usually limit you to three discount point purchases.

We use mortgage points and discount points interchangeably here since mortgage discount points are much more likely than mortgage origination points to impact your home purchase process.

What is a mortgage point worth?

One mortgage point is usually equivalent to one percent of the full loan amount. For example, one point on a $500,000 mortgage should cost $5,000. Your interest rate will typically lower about 0.25 percent for each point purchased, although this depends on your lender, the type of mortgage loan, and the interest rate ecosystem in the current housing market.

What are the pros and cons of buying points on a mortgage?

It’s important to understand if buying mortgage points makes sense for your situation. Here are the pros and cons.

Pros 

• Paying points on a mortgage means that if you plan on living in your new home for a long time, you will most likely save money over the life of the loan. You can use a mortgage calculator to determine how much money you can save over varying amounts of time by investing in mortgage points during your closing process.

• It might help you qualify for your mortgage loan. Although it may seem counterintuitive, securing a lower interest rate by buying mortgage points might help you receive mortgage approval on your dream home, even with a lower income.

• You can receive a tax deduction on discount points purchased when buying or building your home and sometimes when you refinance your mortgage.

Cons

• Buying points on a mortgage can be a significant up-front investment. Many people cannot afford to spend more money to purchase mortgage points in addition to their down payment. Even if you have enough money saved to buy discount points, sometimes it might make more sense to invest that money in a mutual fund or stock market, where you may see more return on your investment than money saved long-term by purchasing mortgage points.

• Depending on your financial situation, buying mortgage points may increase your chance of needing private mortgage insurance, or PMI. If you choose to set aside some of your down payment for buying points, you take the risk of having less than 20 percent equity in your home at the time of purchase. If that’s the case, most lenders will require you to purchase private mortgage insurance—possibly more trouble than it’s worth.

What else do I need to know about mortgage points?

Comparing different loans and figuring out your mortgage can be confusing. One helpful solution is to use the annual percentage rate, or APR, to compare loans. The APR will show you the yearly interest, as a percentage, that you will be charged as a borrower to pay to your lender. You can use this percentage to compare interest rates from various potential lenders, and you can use a mortgage calculator to figure out how mortgage points might come into play.

If you’re considering buying mortgage points, you’ll want to calculate your break-even point: the length of time spent in your home in which you will break even for the amount spent on prepaid interest. If you’re considering paying off your mortgage early, buying mortgage points might not be the best option.

Once you have determined if paying points on a mortgage will work for your financial situation, it’s time to sign up for a home warranty to help ensure that your budget is protected. An American Home Shield® home warranty can help keep your home systems and appliances running smoothly and your budget in check. Compare pricing and plans today to find the best home warranty coverage for your household.