What are Mortgage Points and Should you Pay Them?
In a simple world, mortgage points wouldn’t exist. They were invented by the mortgage industry ostensibly to give you more options when taking out a mortgage. In actuality, they function mainly to increase certainty (you are essentially increasing the size of your down payment), and hence the bank’s profits.
Simply stated, a mortgage point represents 1% of the mortgage amount, equivalent to prepaid interest. The idea is that by paying upfront discount points to the broker, you can achieve a rate below par - that which a borrower of similar circumstances/creditworthiness could expect to pay. On the surface, this seems like a great deal, since you only have to pay the discount points once, and you get to realize savings in the form of lower monthly payments for the entire duration of your mortgage.
Of course, there’s no such thing as a free lunch. The points will have been calculated very precisely by your mortgage originator based on his required rate of return. In other words, he makes an assumption about the return he can achieve on your upfront payment, such that if invested properly it will offset the lower mortgage payments he will receive from you. Naturally, you want to attempt to back out this rate of return, in order to determine whether the savings are sufficient enough given the number of points you are being charged. In other words, if you simply took the additional upfront payment and deposited it in a savings account, would it return more than what you otherwise would have saved by paying points?
The simplest, and perhaps most useful points calculation is that of the “break-even point.” This is the number of years it will take you to recoup the outlay of points, in the form of savings on your monthly mortgage payment. For example, if you are paying 1 point on a 500,000 mortgage ($5,000), it will take you 10 years (120 months) to break even if you can save $40 a month. Whether or not you think this trade-off makes sense depends largely on how long you anticipate staying in your house. It also depends on whether you can afford the additional upfront costs. For most people, a couple points won’t break the bank, but those who are having difficulty scraping together enough cash for the down-payment probably won’t want to even thinking about paying points, regardless of whether it saves them money in the long-term.
One important consideration when paying points is tax deductiblity. Discount points are considered prepaid interest by the IRS, and are thus fully tax deductible (like normal mortgage payments), as long as certain conditions are met and you didn’t borrow money to pay the points. Origination points, on the other hand, represent normal closing/settlement costs (The IRS lists “appraisal fees, inspection fees, title fees, attorney fees, or property taxes” as examples) and are not tax-deductible.