If you're considering acquiring a mortgage, have you heard of "mortgage points"? You pay your lender directly for mortgage points in exchange for a cheaper interest rate. They are also known as prepaid interest or discount points.

While mortgage points can seem confusing and intimidating, understanding how they work is important to any homeowner's strategy. This post will discuss mortgage points and why they make sense for potential home buyers who want to minimize their total borrowing costs.

How Mortgage Points Work

Mortgage points, which are payments you pay to your lender in exchange for a cheaper interest rate, are also known as discount points or prepaid interest. One point, which can be paid up front or over time, is equal to one percent of the loan amount. Unlike other loan-related fees, purchasing points are regarded as a borrowing cost rather than an additional expense.

The more mortgage points you buy up front, your interest rate will be lower. That's because lenders can offer a discounted rate in exchange for paying more upfront. The opposite is true, too - if you choose not to purchase extra mortgage points at closing, your lender will charge a higher interest rate.

Mortgage points are typically best used in situations where you can afford to pay a higher up-front cost and will be able to benefit from a lower interest rate over the life of the loan. For example, if you plan to stay in your home for many years, it can make sense to purchase additional mortgage points since you’ll end up paying less in interest over time. However, it may not be worth it if you only plan on staying in the home for a few years before selling or refinancing.

Origination Points

Origination points, or origination fees, are the lender's processing fees. It is calculated as a percentage of the total loan amount and can range from 0.5 to 1 percent, depending on your lender. This fee covers the administrative and operational costs of originating and processing your loan.

Typically, the origination charge is stated in "points"; one point is equivalent to 1% of the loan amount. For instance, you would spend $3,000 (1% x $300,000) if you took out a 30-year fixed-rate mortgage at 3% interest with a one point origination fee. For certain borrowers, lenders may not charge this fee, or they may give reductions if more mortgage points are purchased.

Keep in mind that origination points are separate from discount points. Discount points are an upfront payment that can be used to buy down the interest rate on your loan, whereas origination fees do not affect the interest rate and are charged as a fee for processing the loan.

Discount Points

Discount points, also referred to as mortgage points or prepaid interest, are fees that you pay your lender for a lower interest rate. One point equals 1 percent of the loan amount and can be paid upfront or over time. Purchasing parents is considered a borrowing cost rather than an added expense like other loan-related costs.

The more discount points you buy upfront, the lower your interest rate. That's because lenders can offer a discounted rate in exchange for paying more upfront. For instance, a $300k home with a 3% fixed-rate loan with one point would mean paying $3,000 (1% x $300,000) from the beginning.

The key to making the most of discount points is understanding how long you plan on staying in the home. Purchase additional points if you plan on staying in the home for many years, as it can save you money on interest over time. However, if you only plan to stay a few years before selling or refinancing, it may not be worth it.

Calculating Mortgage Discount Points

Calculating mortgage discount points can be a complex process, and it's important to understand how they work before deciding if they are right for you.

The main factor in determining how much your discount points will cost is the interest rate reduction you want to achieve.

The more points you buy, the lower your interest rate will be. Generally speaking, each purchase point costs around 1 percent of your loan amount and provides an equivalent discount on your interest rate. For instance, a $300K home loan at a 3% fixed rate with one point would mean paying $3,000 (1% x $300,000) from the beginning.

In addition to the cost associated with purchasing points, it’s important to consider how long you plan on staying in the home. If you know that you will stay in the home longer than 5-7 years, it can make sense to purchase additional mortgage points, as this can save you money on interest over time. However, it may not be worth it if you plan to move or refinance before then.

It’s also important to understand that mortgage discount points come with risks and rewards. When deciding, consider whether the cost savings outweigh any potential disadvantages of purchasing them.

Example of Paying Discount Points

An example of paying discount points would be when a borrower takes out a 30-year fixed-rate loan at 3% interest with one point. This means that they would pay an extra $3,000 (1% x $300,000) upfront for a lower interest rate. This can be beneficial if the borrower plans to stay in the home for many years, saving them money on interest over time.

For instance, let's say the borrower has two options:

1) Take out a 30-year mortgage without purchasing any additional points and pay 3% in interest or

2) Pay one point upfront ($3,000) for a 2.75% rate instead.

Using APR to Compare Loans

The annual percentage rate (APR) is a key metric used to compare loan offers and understand the total cost of borrowing. It’s important to pay attention to the APR when shopping for a loan, as it includes all finance charges, including interest, fees, and points.

The APR is calculated by adding the mortgage rate and any additional costs associated with the loan, such as origination points and discount points.

This gives you an overall picture of how much you will be paying in interest over the loan's entire life. For example, if two lenders offer loans at a 3 percent interest rate, but one lender has higher fees than the other, their APR may differ even though they have the same base interest rate.

FAQs

What do points mean on a mortgage?

Points, also known as discount points or prepaid interest, are fees paid directly to your lender in exchange for a reduced interest rate. One point equals 1 percent of the loan amount and can be used to buy down the interest rate on your loan.

What does APR mean for a mortgage?

The annual percentage rate (APR) is the total cost of borrowing, including all finance charges such as interest rates, origination points, and discount points. It’s important to pay attention to the APR when shopping for a loan to compare offers and understand the cost of borrowing.

Should I pay points on my mortgage?

Whether you should pay points on your mortgage depends on how long you plan on staying in the home. If you’re planning on staying for many years, it can make sense to purchase additional points, as this can save you money on interest over time. However, if you only plan to stay a few years before selling or refinancing, it may not be worth it.

Conclusion

Mortgage points can effectively save money in the long run by lowering your interest rate and total borrowing costs. It’s important to understand what mortgage points are and how they work so that you can make an informed decision when shopping for a loan. With this information and some careful calculation, potential homeowners will be able to determine whether paying mortgage points is right for them and