|By David Pilley on July 27, 2010
If you are new to purchasing a home, the most important factor lies in the mortgage. The mortgage is the loan you have received from the bank to live in the home, and you pay it back to the bank in monthly amounts. Like every loan, a mortgage has interest. If you have bad credit, your interest rate will be higher. However, there is a way to prepay the interest and, in a sense, lower it.
Mortgage points can be purchased for this very purpose. A mortgage point is equivalent to one percent of the principal amount of the loan. (For example, if the total mortgage is $75,000, one point equals $750.) There are two types of points that may be available: origination points and discount points.
An origination point can be purchased to pay for the cost of obtaining the actual loan. While an origination point can pay back a portion of the original mortgage loan, it is not tax-deductable, so it is not nearly as popular as the second type of mortgage point.
If you’re looking to lower, or “buy down”, the interest rate of your mortgage, then you should purchase a discount point. Just like an origination point, one is equivalent to one percent of your total mortgage loan. Now, there will never be enough points offered by your lender to completely eliminate the interest rate, but there may be opportunities to purchase enough points to have a substantial decrease in the interest. A discount point, after all, can benefit both the borrower and the lender. Lenders receive money upfront instead of waiting for it over time, and the borrower pays less in the long run.
Unfortunately, it isn’t an equal payoff. One point (which equals one percent of your total mortgage) will not lower your interest rate by a percentage point. Typically, it will range between one eighth and one fourth of one percent. Still, having a 5.75% interest rate means less money to pay than having a 6% interest rate, so purchasing even one point can benefit you.
However, the savings are not immediate. It may take multiple years to break even. Remember that, when you buy a home, part of the purchase is via down payment, or personal non-loan funds (aka cash). The more your home costs, the more a discount point would also cost. Therefore, you would benefit more from a discount point if you plan on living in the home for many years. (The most basic formula shows a loan amount of $100,000, a term of 30 years, and an annual interest rate of 6%. If you purchase two points, you will pay $2,000 upfront, and the interest rate will be lowered to 5.5%. However, it will take you 63 months [over five years] to recover the $2,000.) You can visit this site to calculate other scenarios.
And, where the origination point is not tax-deductable, the discount point is, as you will find it under Schedule A of your IRS 1040 form. You purchase the point(s) at the closing, where the property legally changes hands. So, do some research, some thinking, and some collaboration, and if you decide to purchase points, you might just score.