Understanding Mortgage Discount Points and How to Use Them
Buying a home is an exciting time! However, there is a certain amount of anxiety that goes with it, especially when you add in all the real estate lingo that most people who are not in the industry don't thoroughly understand. But, that's what your real estate agent is for.
Your agent is there to assist you every step of the way, so don't hesitate to pick his or her brain if there is anything you don't understand.
One of the most common real estate related questions agents receive is, "What are mortgage points and how do I use them?" Well, that's a great question and since it's asked so often, here is a quick overview about mortgage points, how a home buyer might use them.
Have questions about your mortgage? Always consult with your mortgage lender for advice specific to your needs.
What Are Home Mortgage Points?
Mortgage points, also known as mortgage discount points, are basically prepaid interest. More specifically, mortgage points are fees you have paid to your lender at closing, which are used in exchange for a lower interest rate. The more points you have, the lower your interest rate will be.
There are two types of mortgage points:
- Discount Points. Discount points are the prepaid interest mentioned above. The more points you pay, the lower your interest rate will be on your loan.
- Origination Fee. The origination fee is charged by the lender to cover the expenses of making your loan.
How Do Mortgage Points Work?
Every point is the equivalent of one percent of your mortgage total. For example: You would pay $1,000 (which is the equivalent of one point in this example) for every $100,000 of your loan. In summary, the borrower is paying some of their mortgage interest up front, and in exchange, they receive a lower interest rate over the life of the loan. This could ultimately save a significant amount of money in interest costs. However, there are some circumstances when paying points may not be the best way to go - which will be reviewed in the next section.
Should You Pay for Mortgage Points?
Paying mortgage discount points, also called buying down the interest rate, is usually only recommended if you plan on staying in your home for a long period of time. The reason is that a lender only realizes the savings from the discount points (the lower rate of interest) over the life of the loan. That means you have to calculate how long it will take for your upfront cost of the points to equal out to the savings you would be receiving on your monthly mortgage payment. This is what is called the break-even period.
There are plenty of mortgage points calculators online that can be used to determine the break-even period. You can also ask your real estate agent for a mortgage company referral and they will most likely have calculators that you can use as well.
So how should you decide whether or not to pay for mortgage points? Well, first you will need to ask yourself how long you plan on staying in your home. Secondly, you will need to assess your finances. Paying mortgage discount points will depend on how much of a downpayment you have.
As is the case with many financial decisions, some professionals might argue that the money you would spend buying down your rate would better serve you if invested it in other financial or fixed assets for a higher return. However, as with many financial investments, there is usually some degree of risk. Spend some time researching this issue, so you can make an educated decision about which route is financially the best for you. As always, be sure to ask a financial expert for their opinion.
Can You Accept Third-Party Contributions for Mortgage Points?
In most cases and in most states, a homebuyer can accept third-party contributions for mortgage points. Some new home builders may even offer to pay for points as an incentive for buying one of their homes. In the same respect, you can also negotiate with a seller to pay for your points which will lower the amount of cash you will have to come up with at closing. However, there are some limits to how much a third-party can contribute; therefore, you will need to talk with your lender about their restrictions, before you proceed with any of these options.
Can a Homebuyer Use Mortgage Points as a Tax Deduction?
The good news is that, in most cases, mortgage discount points are tax deductible. However, there are certain requirements that must be met for your points to be considered as tax deductible. A taxpayer can deduct mortgage points in full in the year in which you paid them if:
- Your permanent residence (your main home) is used to secure your loan.
- Paying points is a supported practice in your area.
- The points you paid did not equate to more than the amount that is typically paid in your area.
- You use the cash accounting method, which means you report all your income in the year you received it and deducted your expenses in the year you paid them.
- The points you paid were not for items that are normally listed as a separate line item on the settlement sheet.
- You didn't borrow the funds from your lender to pay the mortgage points.
- You used your loan to buy or build your main home.
- Your points were calculated as a percentage of the principal amount of your loan.
- The amount you paid for your points is specifically listed as points on your settlement statement.
Everybody's tax situation is different, so be sure and check with a tax specialist about the deduction of mortgage points on your tax return.
Mortgage points, interest and even obtaining a mortgage are complicated and often confusing. Though some facets of mortgage points are covered in some detail above, often the best resource for mortgage questions is your real estate agent or a mortgage broker. They are here to help you and answer all those mortgage point questions.