Should I Buy Mortgage Points?

Most people haven't the slightest idea what is meant by "points". If you've been shopping around for a mortgage you have undoubtedly heard this term mentioned many times. But if you are like most people, you won't know what it means.

Mortgage points usually refer to discount points. Each point is equal to one percent of the amount borrowed. For example, on a $300,000 loan one point is $3,000, on a $350,000 loan one point is worth $3,500.

For every point you pay, the lender will lower your interest rate. When you purchase points, you are basically prepaying part of your mortgage interest. The amount of the decrease can vary, but it is typically about a quarter of a percentage point per discount point purchased.

For example, if you borrowed $200,000 and bought two points, it would cost you $4,000 and your rate would drop by half a point. Most lenders will allow you to purchase up to three or four points.

But before you rush off to buy all the discount points you can, there are a couple things you need to consider.

First, can you afford to purchase points? Or would the money do you more good elsewhere. Most people are pretty strapped for cash when they buy a new home. You'll have to pay the down payment, closing costs, and moving expenses. And you'll probably want to do some work on the house to make it your own. Those points could pay for some painting, landscaping, or other projects.

Even if you have the extra cash and don't want to put it toward the down payment or home improvement projects, you can likely get a better return elsewhere. Think about it. If you bought three points on a $400,000 it would cost you $12,000. If you invested that money in stocks or bonds, you can likely earn more than you would save by buying points.

The other major consideration when deciding whether or not to buy points is how long you expect to live in the home. The longer you expect to stay, the better deal points offer.

Buying discount points is simply prepaying part of your mortgage interest upfront. Since you paid upfront, the lender comes out ahead for the first few years. But eventually your monthly savings exceeds the amount you paid upfront, and you end up the winner.

So the key is to calculate the breakeven point. If you leave before the breakeven point, the bank wins. If you leave after, you win.

How long it takes to reach the breakeven depends on your interest rate and the amount you paid in points, but for most loans it falls between five and six years. You should use an online calculator or ask your lender to break down the numbers for you so you can determine the breakeven point for yourself.