Mortgage rates have hit record-setting lows time and time again in 2020, offering Americans a chance to save big when either buying a home or refinancing their existing one.
Those bargain-basement rates aren’t available to just anyone, though. The lowest rates are usually reserved for borrowers with the best credit. So increasing your credit score? That can help your case a lot. Because rates vary from one lender to the next, so can shopping around for your mortgage company.
If you’re willing to do some careful calculations, there’s also a third, lesser-known way to snag a low interest rate and save cash over the long haul: Buy mortgage points.
What are mortgage points?
When you apply for a home loan, you’ll have the opportunity to buy mortgage points. Each point costs 1% of your loan amount and lowers your interest by a small, fractional amount.
“Mortgage points — or discount points — allow you to pay more in closing costs in exchange for a lower mortgage rate,” says Lucy Randall, director of sales at mortgage lender Better.com. “That means you’ll have a bigger upfront fee, but a lower monthly payment over the life of your loan.”
Many people call paying points “buying down your rate.” The exact amount that a point can lower your rate varies, depending on your loan, lender and the overall investment market. Usually, it’s anywhere from one-eighth to one-quarter of a percent, Randall says.
Here’s an example of points in action: Say you were quoted a 3.5% interest rate on your $200,000 loan but were really hoping for a 3% rate. Points could help you achieve that.
According to your lender, a point is currently worth 0.25. That means to lower your rate by 0.50, you’d need to buy two points. At 1% of your loan amount each — or $2,000 — that’d mean a grand total of $4,000 to snag that 3% rate you were gunning for. (It would also mean shaving $55 off your monthly payment).
Points don’t have to be round numbers. If you only wanted to lower your rate slightly, you could buy half a point, for example. In the previous scenario, that’d mean a rate of 3.375% — a reduction of 0.125.
There aren’t any hard-and-fast limits on how many points you can buy. According to Randall, though, “You'll rarely find a lender who will let you buy more than around four.”
Are points worth it?
Points clearly have advantages, helping borrowers snag a lower rate and save on interest in the long-term. But are they right for everyone? Definitely not.
For some, they could be a costly mistake.
“There is an emotional pull with homebuyers because they think they want the lowest rate available, but it doesn’t always work in their best interest,” says Omeed Salashoor, sales manager and certified mortgage planning specialist at Homebridge, a New Jersey-based mortgage company. “Buying points works for the buyer when they anticipate staying in the house for a significant period of time.”
That last part is key when determining if points are a smart investment. Because points come with an upfront fee, you’ll need to make sure you stay in the home long enough to recoup the costs. If you know it’s your forever home and you plan to live there for the long haul, then you’re probably safe. But if it’s a starter home or you only expect to stay there a few years, that’s where it gets murkier.
Let’s return to our previous scenario, where you paid $4,000 to lower your interest rate to 3%, shaving $55 off your monthly payment. To make that investment worth it, you’d need to stay in the home until at least the breakeven point. In this case, that would be nearly 73 months, or just over six years ($4,000 / $55). If you’re not sure you’ll keep the property that long, then points probably aren’t the best move.
“Paying mortgage points can save you money over the life of your home loan if you don’t sell or refinance for many years,” Randall says. “Understand, though, that the upfront investment can be substantial.”
Another consideration? That’d be how it impacts your down payment. If paying for points would eat into the cash you intend to put down, you might want to think twice. Making a down payment of less than 20% would generally mean owing mortgage insurance, which costs around $30 to $70 per month.
Why do points exist?
According to Jon Ingram, senior mortgage advisor for The Yi Team Mortgage in Maryland, points “have been around a long, long time.”
That’s because they encourage borrowers to keep their loans longer — offering a potentially extended period of profits for lenders and investors in the mortgage market.
“Points are beneficial from the lenders’ and investment community’s perspective in that it discourages serial refinancing and prepayments,” says Marina Walsh, vice president of industry analysis at the Mortgage Bankers Association. “That steadiness is what the investor community is looking for. They know the loan won’t prepay, which means they’d lose their investment at that point in time.”
Though lenders don’t have any outright guarantees a borrower with points will keep their loan longer, there’s certainly the extra motivation to do so.
As Walsh puts it, a borrower who pays for points “has to think long and hard about refinancing.” If they haven’t recouped the costs of those points yet, they could lose out on money — plus owe the additional fees and closing costs for refinancing on top of that.
It’s this potential for extended returns that makes investors willing to accept lower interest rates. Keep this in mind if a lender offers you a lower rate, and be extra sure the points work in your favor — not just the investor’s.
“Many lenders automatically charge discount points in order to show the borrower a lower interest rate,” says Hernan Garcia, producing branch manager at Oakdale Mortgage. “This is not always the appropriate thing to do.”
Points, but in reverse
Points aren’t the only way you can wheel and deal with your rate. If you’re willing to go the other direction — and take on a higher interest rate, your lender can give you what’s called a credit.
A lender credit works like points — but in reverse — and actually helps lower your costs at closing. In our previous example, if you took on a rate 0.25 higher (3.75% instead of 3.5%), you’d be credited for a full point — or $2,000.
Credits can make sense if you don’t have much saved for your upfront costs but know you can make a higher monthly payment.
“A lot of first-time homebuyers are scrapping together most of their savings to acquire their first house,” Ingram says. “Lender credits can go a long way toward reducing the closing costs they will encounter.”
Credits aren’t ideal if you plan to be in the home for an extended period of time, because they come with much higher interest costs in the long run. If you do plan to stay a while, you’ll want to refinance when possible to reduce your costs.