One of the factors that affect the cost of a mortgage are "points." You hear about them in the ads, see them in the fine print. Rates are advertised to be "as low as" some eye-catching number, but the lender often neglects to mention this number only drops so low when discount points are purchased.
What are points when it comes to mortgages?
A point represents one percentage point of the loan amount. There are two kinds of points: origination points to get the ball rolling (sometimes called buying points) and discount points to lower the interest rate. Whether you're buying a home or refinancing your existing home, you face the question of points.
The lender charges you points to originate the loan. The fee generally ranges from 0.5% to 1.5% on a typical mortgage loan. That means for a $300,000 loan, typical origination feels would be $1,500 to $4,500.
Even people with only a glancing familiarity with mortgages have heard of closing costs. Well, origination points represent one of the most substantial closing costs for a mortgage or refinance. As such, they must be listed on the good faith estimate you get from a lender.
Most private lenders require origination points to be paid. This money in their pocket is an instant return on their investment. A person's ability to pay origination points also reflects on his or her financial responsibility and helps the lender assess whether the person is a good risk for a home loan.
Even veterans who get their mortgage through a VA loan program face paying origination points because the points are established by private lenders, not the Veterans Administration. VA loans bring valuable benefits to qualifying veterans, such as no down payment and no private mortgage insurance (PMI), but the loan money always comes from a private bank or lender.
On the other hand, federally backed mortgages, such as those made through the Federal Housing Authority (FHA), do not require points to be paid.
Origination points are negotiable.
As closing costs, origination points fall under the category of negotiable fees. Some closings costs are set by a third party, but every lender sets its own origination fees and can lower them at will. The better your credit score, the stronger negotiating position you're in.
Lowering your closing costs is difficult but not impossible, says residential real estate broker Dave Sutton. The reason is that some costs are fixed by third parties, as we mentioned, and others represent prepayments of things you must pay anyway. For example, closing costs might include paying the first year's home insurance premiums up front; you can't negotiate to pay no home insurance.
"You certainly have nothing to lose by negotiating home refinance closing costs with your lender or bank representative," advises Bryan Dornan at Refi Guide. "You may even qualify for a refinance mortgage with no closing costs."
Location, location, location.
Where you buy a home or refinance has a lot to do with how much you pay in total closing costs. You might be able to negotiate hundreds of dollars off the fees that are within the lender's power to change, but there's no wiggle room when it comes to such things as city, county, and state transfer taxes; prepaid property taxes; and recording fees.
The states with the highest average closing costs in 2019, including taxes, are listed below, according to a survey by ClosingCorp, which provides residential real estate closing cost data and technology for the mortgage and real estate service industries. (Data for 2020 hasn't been reported yet.) Highest closing costs:
District of Columbia, $25,800
New York, $12,847
The states with the lowest closing costs, including taxes, were:
South Dakota, $2,159
When you get approved for a loan, the lender will typically offer you multiple rates, starting with a base rate. The other rates will be available to you if you buy one or more discount points. One point will cost 1% of the loan amount. Generally, each discount point you buy will lower the interest rate by 0.25%. Lenders will permit you to buy as many as four discount points.
Why would someone pay 1% now to save 0.25% on interest? Because if you plan to own the home at least 10 years, you'll save money. You reach a breakeven point relatively soon. Over the loan term, the money you save can be substantial.
Let's say you buy one discount point on a $300,000 fixed-rate loan; the point costs you $3,000 (1%). This point entitles you to a drop in interest rate, from 2.95% to 2.70%, for the 30-year term of the loan.
If you hadn't lowered your interest rate, your payment would have been $1,257. With the discount point you purchased, your payment is $1,217. You're saving $40 a month, which means that you break even with the cost of the discount point in 75 months (3,000 divided by 40)—that's just a little over six years. After that, you keep saving $40 every month for almost 24 more years.
A discount point costs cash up front, but you reach the breakeven point relatively soon in a loan period. After that, it's all savings.
Remarkable long-term savings.
To appreciate the benefits in the bigger picture, let's focus not on monthly payments but on interest paid over 30 years. Let's use the same example of a $300,000 loan at a fixed rate for 30 years. At the original 2.95% rate, you would pay $152,425 in total interest. Because you bought a discount point and lowered your rate to 2.70%, you pay $138,045 in total interest.
In the big picture, that $3,000 point you bought saves you $14,380 in interest. That's your purchase price plus $11,380 icing on the cake, almost a quadruple return on your investment. No wonder lenders limit the number of discount points you can buy to four.
Points When Purchasing vs. Refinancing
Purchase-loan discount points are usually tax-deductible, but refinance loan discount points are different. "You can deduct only for the percentage of the discount point proportionate to the number of payments you made in the year you are filing taxes," writes Andrew Latham for the Home Guides section of SFGate.
He gives this example: "Let's say you paid for one point that cost $1,000. If there are 100 payments in the refinance loan and you made 12 payments in the year, you could only deduct $120 ($1,000 divided by 100, times 12). However, if you are using the mortgage refinance to increase the value of your home—also called capital improvement—you can deduct the entire buying point from your tax return in the same year you pay for the point."
On the subject of taxes, origination/buying points and discount points are different. While discount points are usually tax-deductible in some fashion, origination points never are.
- Origination (buying) points are among the closing costs of a home loan.
- Origination points are negotiable; the better your credit score, the stronger your position.
- Discount points are money spent up front to lower your payment and save much bigger money in the long term.