If you are planning to buy a property, you may have heard of the term “points” in relation to real estate financing. But what are points and how do they affect your mortgage? In this article, we will explain what points are, how they work, and why you should consider them when choosing a loan for real estate investment.
What Are Points?
Points are a fee that a borrower pays to the lender to get a lower interest rate. One point costs one percent of your overall mortgage amount. You will pay this fee up front, but secure a lower interest rate for the rest of your payoff period (often 15 or 30 years). This can result in savings over the long-term, even though you pay more initially.
There are two kinds of points: origination points and discount points. Origination points are used to compensate the lender for the creation of the loan itself, whereas discount points are used to buy down the interest rate of the loan. Origination points are not tax deductible and many lenders have shifted away from them, offering flat-fee or no-fee mortgages instead. Discount points, on the other hand, are tax deductible and can be a smart way to reduce your interest cost over time.
How Do Points Work?
To understand how points work, let’s look at an example. Suppose you want to buy a property worth $300,000 and you have a 20% down payment ($60,000). You need to borrow $240,000 from the lender. The lender offers you two options:
- Option A: A 30-year fixed-rate mortgage with an interest rate of 4% and no points.
- Option B: A 30-year fixed-rate mortgage with an interest rate of 3.75% and two points.
If you choose option A, your monthly payment will be $1,146 and your total interest cost over 30 years will be $172,489.
If you choose option B, you will have to pay $4,800 ($240,000 x 0.02) in points up front, but your monthly payment will be $1,111 and your total interest cost over 30 years will be $159,845.
As you can see, option B saves you $35 per month and $12,644 in total interest, but it requires you to pay $4,800 more at closing. To decide which option is better for you, you need to consider how long you plan to stay in the property and whether you have enough money to pay for the points.
Why Should You Consider Points?
Points can be a good option for borrowers who want to lower their interest rate and save money in the long run. However, points are not for everyone. Here are some factors to consider before buying points:
- How long do you plan to stay in the property? The longer you stay, the more you will benefit from the lower interest rate. If you plan to sell or refinance in a few years, you may not recoup the cost of the points. A general rule of thumb is to buy points if you plan to stay for at least five years.
- How much money do you have for closing costs? Buying points will increase your closing costs, which are typically 2% to 5% of the loan amount. You need to have enough cash to cover the points and other fees, such as appraisal, title, and escrow. If you don’t have enough cash, you may have to borrow more or get a higher interest rate.
- What is your tax situation? Discount points are tax deductible, which can lower your taxable income and save you money on taxes. However, the tax benefits depend on your income, filing status, and other deductions. You should consult a tax professional to determine how points will affect your taxes.
Points are a fee that a borrower pays to the lender to get a lower interest rate on a mortgage. Points can help you save money on interest over time, but they also increase your closing costs and require you to pay more up front. Before buying points, you should compare different loan options, consider your financial goals, and consult a tax professional. According to Investopedia, you can use the annual percentage rate (APR) to compare the cost of loans with different points and interest rates. The APR includes the interest rate and the points, as well as other fees and charges. The lower the APR, the better the deal.