When securing a mortgage, one of the key decisions you’ll face is whether to buy points to lower your interest rate. Mortgage points, also known as discount points, are a type of prepaid interest where you pay an upfront fee to reduce the interest rate on your loan.
Each point typically costs 1% of the loan amount and reduces your interest rate by a small percentage, usually 0.25%. While buying points can save you money over the life of the loan, it also requires a significant upfront investment.
In this article, we will explore the pros and cons of buying points on a mortgage, helping you determine whether this option aligns with your financial goals.
Pros Of Buying Points On A Mortgage
1. Lower Interest Rate
The primary benefit of buying mortgage points is the reduction in your interest rate. A lower interest rate means lower monthly mortgage payments, which can make your loan more affordable over time. This can be particularly advantageous if you plan to stay in your home for a long time, as the savings on interest can accumulate significantly over the life of the loan.
2. Long-Term Savings
By reducing your interest rate, buying points can lead to substantial long-term savings. Even a small reduction in your interest rate can result in thousands of dollars in savings over a 15- or 30-year mortgage. These savings can be particularly beneficial for homeowners who plan to keep their mortgage for the entire term of the loan, as the cumulative interest saved can outweigh the upfront cost of the points.
3. Predictable Monthly Payments
Lowering your interest rate through buying points results in lower monthly mortgage payments. This can make your housing expenses more predictable and easier to manage within your budget. For those on a fixed income or with strict financial plans, the ability to reduce monthly expenses by buying points can offer valuable financial stability.
4. Tax Deductibility
In many cases, the cost of buying mortgage points is tax-deductible, which can provide additional financial benefits. The IRS allows you to deduct the cost of points in the year they are paid, provided the loan is used to purchase or improve your primary residence. This deduction can reduce your taxable income, effectively lowering the overall cost of buying points and making it a more attractive option.
5. Greater Equity Accumulation
With lower monthly payments and less interest accruing over time, a larger portion of your payments goes toward reducing the principal balance of your loan. This allows you to build equity in your home more quickly, which can be beneficial if you plan to sell your home or refinance in the future. Increased equity can also provide a financial cushion, giving you more flexibility in managing your finances.
6. Protection Against Rising Interest Rates
If you secure a lower interest rate by buying points, you are protected from potential future rate increases. This is particularly valuable in an environment where interest rates are expected to rise. By locking in a lower rate through points, you ensure that your mortgage payments remain stable, regardless of market fluctuations.
7. Flexibility In Loan Terms
Buying points can offer flexibility in your loan terms. For example, you may choose to buy points to reduce the interest rate on a shorter-term loan, such as a 15-year mortgage. The combination of a lower interest rate and shorter loan term can lead to even greater savings, allowing you to pay off your mortgage more quickly and reduce the overall cost of homeownership.
8. Competitive Edge In A Seller’s Market
In a competitive housing market, being able to secure a lower interest rate can make your offer more attractive to sellers. Lower monthly payments may also allow you to qualify for a larger loan, giving you more purchasing power. This can be an advantage when competing with other buyers for a desirable property.
9. Customization Of Loan
Buying points allows you to customize your mortgage to better fit your financial situation. Whether you want to reduce your monthly payments, save on interest over time, or increase your equity, purchasing points provides a way to tailor your loan to meet your specific needs and goals. This customization can enhance your overall satisfaction with your mortgage and improve your financial outlook.
Cons Of Buying Points On A Mortgage
1. Significant Upfront Cost
One of the major drawbacks of buying points is the significant upfront cost. Since each point typically costs 1% of the loan amount, the expense can add up quickly, especially on larger loans. For example, on a $300,000 mortgage, one point would cost $3,000. This additional cost must be paid at closing, which can strain your budget or deplete savings that could be used for other purposes, such as home improvements or an emergency fund.
2. Long Break-Even Period
The break-even period is the time it takes for the savings from the lower interest rate to equal the upfront cost of the points. If you plan to stay in your home for a shorter period than the break-even period, buying points may not be financially beneficial. For example, if the break-even period is seven years and you sell your home after five years, you may not recoup the cost of the points, making the investment a poor financial decision.
3. Opportunity Cost
The money used to buy points could potentially be invested elsewhere for a higher return. For example, instead of paying for points, you could invest the funds in the stock market, retirement accounts, or other investments that may offer a higher rate of return. The opportunity cost of buying points should be considered, especially if you have other investment opportunities with greater potential for growth.
4. Reduced Cash Reserves
Paying for points at closing reduces your available cash reserves. This could leave you with less money for other expenses, such as moving costs, furnishing your home, or unexpected repairs. Maintaining adequate cash reserves is essential for financial stability, particularly in the early years of homeownership when unexpected expenses are more likely to arise.
5. Potential Loss If Refinancing Or Selling Early
If you refinance or sell your home before reaching the break-even point, you may not fully realize the benefits of buying points. The upfront cost of the points may not be recovered through the interest savings, resulting in a net loss. Homeowners who anticipate moving or refinancing within a few years may find that buying points is not a cost-effective option.
6. Complexity In Decision-Making
The decision to buy points adds complexity to the mortgage process. It requires careful analysis of your financial situation, the break-even period, and your long-term plans. For some borrowers, this added complexity can be overwhelming, leading to confusion or indecision. It’s important to fully understand the implications of buying points and to seek professional advice if needed to make an informed decision.
7. Limited Immediate Benefits
While buying points can result in long-term savings, the immediate benefits are limited to a lower monthly payment. The upfront cost can be substantial, and the financial relief from the reduced interest rate may take years to materialize. For homeowners seeking immediate financial benefits, such as lower closing costs or increased cash flow, buying points may not be the best option.
8. Impact On Loan Flexibility
Buying points can reduce the flexibility of your loan, particularly if your financial situation changes in the future. For example, if you need to refinance or sell your home, the money spent on points is essentially lost. This lack of flexibility can be a disadvantage if you anticipate significant life changes, such as a job relocation, family expansion, or other factors that might necessitate a change in your mortgage.
9. Possible Regret
If interest rates fall after you purchase points, you may regret the decision. While buying points locks in a lower rate, it also means you cannot take advantage of further rate reductions without refinancing, which may involve additional costs. The potential for future rate drops can lead to second-guessing the decision to buy points, particularly if rates decline significantly.
10. Not Suitable For Short-Term Loans
Buying points is generally not advantageous for short-term loans, such as adjustable-rate mortgages (ARMs) with initial low rates or loans with short amortization periods. The break-even period may extend beyond the initial fixed period of an ARM or the loan term itself, making it difficult to recoup the cost of the points. Borrowers with short-term loans may find that buying points offers little financial benefit.
11. Risk Of Overpaying
There is a risk of overpaying for points, particularly if you are not well-informed about current market conditions or if the lender’s offer is not competitive. Some lenders may offer points at higher costs than others, or the reduction in interest rate may not be proportional to the cost. It’s important to shop around and compare offers from multiple lenders to ensure that you are getting a fair deal when considering buying points.
12. Incompatibility With Other Financial Goals
If you have other financial goals, such as paying down high-interest debt, saving for retirement, or investing in education, the money used to buy points may be better allocated elsewhere. Prioritizing other financial goals over reducing your mortgage interest rate may provide a better return on investment and contribute more significantly to your overall financial well-being.
13. Less Favorable In A Low-Interest Environment
In a low-interest-rate environment, the benefits of buying points may be less significant. The reduction in the interest rate may not justify the upfront cost, particularly if rates are already near historic lows. In such cases, the potential savings from buying points may be minimal, and homeowners may find that it’s better to keep the cash for other purposes.
Conclusion
Buying points on a mortgage can offer significant benefits, such as lower interest rates, long-term savings, and greater financial predictability. However, the decision to purchase points requires careful consideration of several factors, including the upfront cost, break-even period, and your long-term financial goals.
For some homeowners, the benefits of buying points will outweigh the drawbacks, especially if they plan to stay in their home for an extended period. For others, the high initial cost, potential for regret, and opportunity costs may make buying points less appealing.
Ultimately, whether to buy points on a mortgage is a personal decision that depends on your individual financial situation, plans for the future, and risk tolerance. By thoroughly analyzing the pros and cons, seeking professional advice, and considering your broader financial goals, you can make an informed decision that aligns with your needs and helps you achieve long-term financial success.