Should you pay points for a mortgage to reduce your rate? This guide shows you how to calculate whether it's worthwhile or not.
With interest rates rising, many homebuyers are concerned about home affordability. Interest rates affect their monthly mortgage payment, so naturally they’re looking for ways to get a lower rate.
One way to do that is to pay “points” on a mortgage, which effectively means paying money upfront at closing to reduce your interest rate.
But should you pay points for a mortgage? How do you know when it’s worth it? We’ll explain the different factors to consider in this article.
Before we get into the pros and cons of paying points, let’s define what a “point” is: A mortgage point is an optional fee you can pay upfront to reduce the interest rate on your home loan.
Each point costs 1% of your loan amount. But here’s the tricky part: there’s no concrete answer to how much each point will reduce your rate. That depends on the current market, the starting rate, the lender, and even the very day and hour you lock.
In some cases, a point might reduce your rate by 0.50% and in others, it won’t even reduce your rate by 0.125%.
This is where your math skills come in. You have to calculate how much you’re saving by paying points and when you recover that cost.
We’ll get into how to figure out whether paying points is worth it.
But back to the definition of a point: It is considered prepaid interest and is titled a discount fee on your final closing statement. No, it’s not because you get a discount necessarily, it’s just mortgage-speak meaning your rate is being lowered from the market rate thanks to your upfront payment.
Why? Well, if you pay a lower interest rate, your lender will earn less money on the loan. The discount points compensate them for the reduced rate while also allowing you to save on interest long-term.
Reducing your interest rate might sound great, especially in the current rate environment. But many borrowers my team and I work with tell us they don’t want to pay any points. After all, paying points means you need more money upfront at closing. That can be difficult for some homebuyers, especially on top of their down payment and other closing costs.
And if they can afford their monthly payment, they see no reason to pay points if they don’t have to. But is a zero points mortgage really the best deal? The answer may surprise you.
The natural question you might ask is why anyone would pay points if they had another option. Since you know you can get a zero points mortgage, why would you voluntarily pay more? The answer lies in what you get in return for paying points.
You might not choose a zero-points mortgage (meaning you would pay points) to reduce your rate and save money monthly over the life of the loan.
So you might pay points upfront if you were pretty sure you would have that loan for a long time, say 15 or 20 years. That’s a lot of months of saving money.
For instance, you pay two points on a $300,000 loan, or $6,000. In return, your payment is $100 less per month (these are completely hypothetical numbers). It takes you 60 months to break even (5 years). If you have not sold the home, refinanced, or paid off the mortgage and you keep the home for 20 years, you saved $100 per month for 15 years.
(The math is a bit more complex than this when you factor in interest savings, but this is a good back-of-the-napkin way of thinking about it. Keep reading for a more in-depth and accurate way to calculate savings or cost.) In addition to monthly savings, paying points helps you save money and pay down your mortgage principal faster.
Unfortunately, there is no straightforward rule of thumb to use to decide whether to get a zero-points home loan. The scenario can change from lender to lender, and even from day to day as mortgage rates change.
The only way to know for sure is to do the math on the offer you’ve been given, ideally working with your lender to understand all of the possible savings and outcomes.
Generally speaking, though, zero-point mortgages tend to make the most sense when you plan to sell the home, refinance or otherwise pay off the mortgage within a few years. If you’ll only be in the house for three or four years, you may not reach a break-even point at which you would recoup the upfront cost for the points.
Conversely, the longer you think you’ll hold on to your home, the more likely it is that you will save money if you buy down your interest rate.
The best way to determine what makes sense for you is to calculate the total cost of each option over time.
To do this, estimate the amount of time you expect to be in your home. This will be the holding period you’ll use to calculate your payments.
If you’re purchasing your forever home, you would want to calculate the full loan term (for example, 30 years). Perhaps this is a starter home, though. In that case, you might estimate that you’ll be in the home for seven years.
But also factor in the possibility that you might (and probably will) refinance sometime in the future. Mortgage points are non-refundable. If you refinance six months later, those funds are gone.
At a time like 2022 when rates have increased dramatically in a short time, there’s a real possibility that rates will again fall in the next five years. If you stay in your home but refinance, points might end up being “pointless”.
That said, taking a seven-year mortgage-holding period as an example, this is how you would calculate whether it makes sense to pay points or opt for a zero-points mortgage:
To figure out your total number of payments, look at the number of months you plan to be in the house. If you expect to stay in the home for seven years, you’d make 84 monthly payments.
Then you can calculate how much you’ll pay in monthly payments during that time. Simply multiply your monthly payment by 84 (or however many months you plan to be in the home).
To calculate how much interest you’ll pay over any period of time, you need to know how much principal you paid.
If you are a whiz with Excel or with an HP12C calculator, you can calculate these numbers yourself and math out exactly which option saves you more money.
But since most people don’t spend evenings and weekends playing with spreadsheets, you can plug your numbers into a mortgage amortization calculator, and look at the remaining balance at the end of 7 years.
Since you know the total number of payments, simply subtract the principal paid and you have the interest cost of your proposed loan over 7 years. Now add in the proposed upfront costs of your mortgage, and you have your total cost.
Do this for each option you’ve been offered to see which makes the most financial sense for you.
That’s OK. You don’t have to, as long as you have a good mortgage advisor. Because you are about to take on what may be the largest debt you’ve ever had in your life, your mortgage advisor should be able to help you work through the different scenarios and choose the one that is most advantageous to you.
Let’s look at how this might break down. We’ll assume a $400,000, 30-year fixed rate mortgage. Note that this example is an illustration of the principle, not an interest rate quote.
| Option | 1 | 2 | 3 |
|---|---|---|---|
| Interest Rate | 4.125% | 4.000% | 3.875% |
| Points (As a % of loan) | 0 | .250 | .625 |
| Points (In dollars) | $0 | $1,000 | $2,500 |
| Mortgage Payment | $1,938.60 | $1,909.66 | $1,880.95 |
| Mortgage Balance after 84 months | $345,223 | $344,238 | $343,241 |
| Total Payments over 84 months | $162,842 | $160,411 | $157,999 |
| Principal Paid over 84 months | $54,777 | $55,762 | $56,759 |
| Interest Paid over 84 months | $108,047 | $104,649 | $101,240 |
| Total Cost over 84 Months | $108,047 | $105,649 | $103,740 |
In this example, paying $2,500 in points upfront would yield a payback of $4,307 (your initial $2,500 investment plus savings of $1,807) over 7 years.
Again, there is no universal rule you can apply to decide whether to pay points for a mortgage.
In many cases, the difference in total cost between paying points or getting a zero-points mortgage turns out to be relatively small.
There are often other considerations, too. For instance, you may need to conserve cash for your down payment and closing costs, in which case a zero-pointss mortgage may be best.
Sometimes homebuyers have to buy down their interest rate to qualify for the mortgage because they need to get the monthly payment down to a qualifying debt-to-income ratio. In that case, the buyer would have to pay points on the mortgage.
Related reading: 2022 Mortgage Rate Forecast: Housing Authorities Weigh in
Your particular circumstances, goals, and concerns may end up being more important than the cost of either option when it comes to paying points.
Knowing the total cost is important information, but it is just information. How you use that information, and whether you choose to get a zero-points mortgage or buy down your interest rate, is something you and your lender should consider carefully together.
Mortgage rate projections are not a reflection of Fairway’s opinion or guarantee of interest rates in the current or upcoming market.
