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By Jamie Smith
Buying a house is the most expensive purchase most people make, so there's good reason to carefully consider all the ways you can save money on your mortgage. One way to save is by shopping around so you can compare rates. Another is by making a large down payment, which reduces the amount of money you need to borrow from a bank or credit union. Buying mortgage points is a third option that can potentially save you money. But how does buying mortgage points work and is it always worthwhile?
The cost of your mortgage is made up of two main parts: Principal and interest. The principal is the amount of money you borrow from the lender, which may be the cost of the house minus your down payment. The interest is the money paid monthly for the use of the loan. The total amount of interest you will pay on a home loan depends on several factors, including the mortgage's length and its interest rate.
Mortgage points offer you a way to reduce your loan's interest rate. They are essentially a way for you to pay interest in advance. You can buy points up front by paying 1% of the principal per point. For instance, if you took out a mortgage for $100,000, each mortgage point would cost $1,000.
For every mortgage point you buy, the interest rate on the loan typically drops by 0.25%. The rate reduction can vary slightly depending on your lender. Some lenders also put a limit on the number of points you can buy, like three or four. Others let you buy half-points, which come with a 0.125% drop in your interest rate.
By paying interest up front, mortgage points allow homebuyers to reduce their monthly mortgage payments. The key question to keep in mind is whether the amount you can save on your monthly payments is more than the cost of buying points up front.
"Discount points" is another name for the mortgage points you can buy to reduce your interest rate. They are typically paid as part of the closing costs of a home loan.
You can include payments towards discount points on your tax return, but not all in the same year. Instead, the amount you spend on mortgage points can be claimed over the lifespan of your loan.
Origination points are charged by some lenders as an administration fee for the mortgage. Some buyers can negotiate the removal of origination points from the overall cost of the loan, especially if they make a large down payment or have a great credit score.
If you do pay origination points, you can't deduct the cost on your tax return because purchasing origination points involves you buying a service.
Before you can decide whether buying mortgage points makes sense, you'll need to think about your future plans. If you intend to stay in your new home for a long time, buying points may be a good investment. On the other hand, if you plan on selling it relatively soon, you may want to consider alternative options to save money.
If you plan on staying in your home indefinitely, buying mortgage points might be a good option. Here is how to figure out the length of time required to benefit from mortgage points.
To help you decide which group you fit into, consider the following example. Two home buyers have 30-year mortgages with a principal of $200,000 and a starting interest rate of 4%. One buyer decides to stick with the standard rate, while the other buys two mortgage points. The second buyer pays $4,000 and secures an interest rate of 3.5%. The home buyer who accepted the 4% interest rate would have monthly payments totaling $954. The buyer who purchased two mortgage points would pay $898, a savings of $56 per month.
Using these numbers, you can work out how long the buyer would need to stay in the house in order to make their points purchase worthwhile. Divide the cost of the points ($4,000) by the monthly savings ($56) you obtain by using the points. The result is 71 months, which is almost six years.
In the example above, it would make sense for the buyer to purchase two mortgage points if they plan on staying in the house for more than six years. On the other hand, if their intention is to sell it after five years and look for another property, the points would cost more than the savings they would make on monthly interest payments. If you know that you plan to stay in your home for a long time, you won't need to figure out the calculations. However, if you consider moving in the next few years, this will be a helpful way for you to determine if buying mortgage points is the right thing to do.
Even if you think you may save a bit of money by purchasing points, you should consider other cost factors before going ahead with a points purchase.
Many buyers don't have the financial resources to make a large down payment and buy mortgage points at the same time. For instance, you may need to choose between making a 20% down payment or putting less money down in order to afford mortgage points. Making a 20% down payment can protect you from additional costs that come with smaller down payments, including private mortgage insurance (PMI).
In this scenario, it may make more sense to focus on the 20% down payment and forget about buying points. That's because reducing your down payment to buy points so you can get a lower interest rate may not result in any savings when the extra cost of PMI is added on.
Another option to consider is to keep the money you would have spent on mortgage points in a high-rate savings account and use it to make higher monthly payments on your mortgage so you pay it off sooner.
Alliant also has a policy of allowing borrowers to pay off their home loan early at no additional charge. If you take this option, you could make big savings on your interest costs.
In summary, mortgage points can save you money, especially if you're planning on staying in your house for a long time. But there are many other ways to save on your interest payments that come with more flexibility and less risk of you losing out.
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