Mortgage points are a simple way for lenders to express a charge that equals 1% of a mortgage loan amount. Points are commonly used to calculate interest rate discounts, origination fees, and lender credits. To help you better understand some of the costs of taking out a mortgage, we've broken down the common definitions of mortgage points.
Mortgage Points Explained
A mortgage point is a charge that equals 1% of a mortgage's total amount. This means for every $100,000 of the mortgage, one point equals $1,000. Points are most often used to calculate discount points, which borrowers can buy from their lenders to lower their mortgage's interest rate. Points can also refer to lender credit or origination points, and are calculated in the same percentage-based way.
|Discount Points...||Lender Credits...||Origination Points...|
Discount points and lender credits are offered to borrowers as a way to alter the payment structure of a mortgage. Discount points are purchased in cash at the beginning of a mortgage's term period to lower the interest rate and save money throughout the life of the loan. In contrast, lender credits are points that a borrower can use to lower the upfront costs of a mortgage. These credits are typically added to the loan balance and paid off throughout the life of the loan.
While buying discount points and lender credits are optional, paying for origination points is required for most mortgages and doesn't alter the mortgage's payment structure. Origination points are used to express the cost of a mortgage's origination fee, which is a service charge for processing a loan application.
Discount points allow borrowers to pay extra upfront cash in exchange for a lower interest rate and a less costly monthly payment. Purchasing one discount point typically decreases the interest rate by .25%. For example, if a borrower buys a point from their lender on a $200,000 mortgage with a 4.5% interest rate, they would pay an extra $20,000 upfront to lower the interest rate to 4.25%. Commonly referred to as "buying down the interest rate," purchasing discount points can help lower the total cost of a mortgage. Discount points are also tax deductible.
The potential drawback of purchasing discount points is that they'll add to the upfront costs of taking out a mortgage. For a homebuyer already struggling to pay their down payment, discount points might create a financial burden. For mortgages with adjustable rates (ARM), which only carry a fixed rate for a few years, discount points only apply for the initial period of fixed rates. For most ARMs, lenders won't apply the discount once the ARM's interest rate begins to vary with the market.
One way to figure out the benefit of purchasing discount points is to calculate the break even point. This will tell you the exact point at which buying down the interest rate begins to pay off. If you plan to refinance or sell your house before the break even point, then buying points won't be worth it. The table below shows the break even point when buying 1 or 2 points for a 30-year, $250,000 loan with a 4.5% interest rate. In this example, buying discount points is only economical if you plan to stay in your home for 6 years.
|Interest Rate||Monthly Payment||Difference in Monthly Payment||Breakeven|
|1 Point: $2,500||4.25%||$1,230||$37 lower||68 Months|
|2 Points: $5,000||4.00%||$1,194||$73 lower||68 Months|
The opposite of discount points, lender credits are used to lower the closing costs of a mortgage in exchange for a higher interest rate throughout the life of the loan. Lender credit is essentially extra loan money provided by the lender upfront, which allows some of the initial costs of borrowing money to be pushed off until a later date. These credits are useful for borrowers who are draining their savings to pay a down payment and don't want to pay more in upfront cash.
Lenders typically charge a variety of closing costs, so reducing the initial cash payment can alleviate some financial pressure. However, it's important to remember that buying lender credits will increase your monthly payment. The example below shows the cost difference for buying 1 lender credit at $2,500 to cover the closing costs for a 30-year, $250,000 loan with a 4.5% interest rate. In this example, getting 1 lender credit increases your monthly payment by $37 — which amounts to a total increase of over $10,000.
|Interest Rate||Monthly Payment||Difference in Monthly Payment||Total|
|1 Credit: $2,500||4.75%||$1,304||$37 more||$10,820 more|
|2 Credits: $5,000||5.00%||$1,342||$75 more||$22,000 more|
Mortgage lenders charge borrowers loan origination fees in exchange for the service of processing a loan application and lending money. These fees are tax-deductible if they meet certain conditions outlined in the IRS Publication 530. Origination points can be deducted either in the year that a mortgage is borrowed, or over the life of the loan — depending on how they're paid. Most lenders charge origination fees that equal 1 mortgage point, or one percent of the total loan amount.
In contrast to discount points and lender credits — which are optional purchases — origination fees are mandatory charges for taking out a mortgage. The government requires that lenders list these costs on the Loan Estimate and Closing Disclosure forms, which lenders provide at the beginning and end of the application process, respectively. Lenders cannot legally raise the origination cost listed on the Loan Estimate, but borrowers with good credit may be able to negotiate a lower fee.