Are Mortgage Points Worth Buying
What Are Mortgage Points
Mortgage points are upfront fees paid to a lender at closing to lower your interest rate. Points sacrifice money today in exchange for a lower monthly payment over the duration of your mortgage. 1 point is equal to a single percentage point of your loan amount. If you are applying for a $250,000 mortgage, a lender might offer a lower rate for 1.25 points. If you took the lower rate, you would need to bring an additional 1.25 / 100 * $250,000 = $3,125 to closing. But are mortgage points worth buying and how do they affect the total cost of your mortgage?
Mortgage Points & APR
One of the things that often entices borrowers to buy points is that mortgages with points carry a lower APR. Lower APR is better than a higher APR so points must be good, right? Well the answer is not always clear and depends a lot on the circumstances of the borrower, particularly how long they expect to remain with their new mortgage. The reason why mortgage points lower APR of a loan is that APR assumes you will stay with the mortgage for the total life of the loan. If you are buying a house with a 30 Year Fixed mortgage, that literally means 30 years! If you are in the mortgage for less than 30 Years, your actual APR will be higher (For more information about how time affects APR, check out our article about APR here). The longer you stay in a loan, the longer you have to average out upfront costs while benefitting from the lower mortgage rate.
Should I Buy Points
Time is the big factor to focus on when considering buying points. When you buy points, you are exchanging cash today in exchange for cheaper monthly payments over time. Buying and selling a house quickly will leave you with a large upfront point fee with little time to recoup savings through lower monthly payments. In a similar mindset, staying in a home for a long period of time allows you to recoup your initial points fees and then some. So the question really is, how long do you need to stay in the mortgage for points to make sense. The “break-even” or “payback period” for mortgage points is simply the cost of the mortgage points divided by the monthly savings from the lower rate. For example, say you spend $2,500 (1 point on a $250,000 mortgage) to save $35 per month by going to a lower rate. Your simple break-even would require you to stay with the mortgage for at least $2,500 / ($35 per month) / 12 months = 6 years to make buying points helpful. Now there is a reason we call it the “simple” break-even. It is digestable and easy to understand, but perhaps at the cost of not giving us the full story.
Why Simple Break-Even Doesn’t Cut It
The simple break even is great and all but there are two main reasons it ends up falling short for most borrowers. The first and most important reason is that things change more often then they stay constant. Without getting too philosophical, consider what factors might change in your own life at some point in the future? Your income will likely increase along with your budget for housing, you might get an opportunity to refinance, a new job opportunity could arise, a marriage could happen, a child might come, mom/dad might need a place to stay, etc. Countless things could happen that might make your new digs and “forever home” not so “forever”.
The other thing to remember about the simple break-even is that it doesn’t take into effect the time-value of money (money in your pocket today is worth more than the same amount in the future). You could use that money to invest in a business, in the stock market, or pay for expenses without having to finance. That last point can’t be said enough. Housing is expensive and new houses often need maintenance and additional furnishing. It is absolutely encouraged to not be cash poor before entering a new home. While seemingly small, the time value of money can have a large impact on your actual break-even point. Our 6 year timeframe from the above example is more close to 8-9 years when you account for the investment potential of the extra upfront fees!
Should I Take a Higher Rate for Negative Points / Lender Credits
If you find yourself in agreement with arguments against buying points, negative or rebate points (taking a higher rate for lender credits at closing) might actually be the best option for you. If you foresee yourself in a house for a shorter period of time, need cash to help with closing costs, or do not want to be cash poor going into a house purchase: taking a higher rate can actually make a lot of sense. Before you go trying to give yourself a 10% mortgage, try to follow these two rules of thumb: (1) Limit any increases in rate to no more than 3/8ths (0.375%) and (2) try to cover closing costs if possible but don’t go much beyond that. In addition, go through the same logic as you would with buying points. Calculate your break-even and really think it through if it makes sense for your situation.
Tax Implications of Points/Rebates
Mortgage points are tax deductible. Though it will only be applicable if you itemize deductions on your taxes as opposed to taking the standard deduction. Because the standard deduction nearly doubled in 2018 ($13,000 to $24,000 for a family and $6,500 to $12,000 for singles), far fewer filers are itemizing. If you do itemize, you can deduct the entire mortgage point in the year you paid for the loan if the mortgage was used for your primary residence. If you have a large loan, remember that points and interest are only deductible on your first $750,000 of indebtedness. In the case of lender credits or rebate points, those are not taxable.