What is 1 point on a mortgage?

Mortgage terms are confusing, that’s for sure. And near the top of the list is the phrase “1 point on a mortgage.”  Especially for new home buyers, when a mortgage loan officer asks, “do you want to buy a point?” the question can produce some puzzled looks. Some people might be worried about not seeming experienced, so they don’t ask for clarification, and then they don’t get the information they need.

But I’m going to break it down for you in a way that’s easy to understand. And then we’ll do a little exercise to see an example of how you might decide if a point is a thing you want to buy on your mortgage.

But first, here’s a simple 3 minute video I made that explains what 1 point on a mortgage is, what the purpose of it is, and how to decide if should buy a point or not.

So, as you can see, 1 point on a mortgage is equal to 1% of the loan amount. You’d pay that amount at the time of closing in exchange for an average of a .25% reduction on your interest rate. You can buy fractions of a point, such as half a point and more than one point, like two points.

Time is a big factor when choosing to buy a point

As I mention in the video, how long you’ll be in a mortgage should be a big factor when deciding on whether to buy a point. Buying a point decreases your interest rate by about 0.25%. But you pay 1% of your loan amount upfront in order to get that decrease.

Because a lower interest rate lowers your monthly payment, the longer that you stay in your home without refinancing or selling, the bigger a benefit you’ll get from a decrease in interest rate.

An exercise: where is the “breakeven” when paying a point?

Let’s do an exercise for how long you’d need to be in a mortgage in order to benefit from buying a point in the current interest rate environment. To put it a different way, when will you “breakeven” – that is, recoup the cost of paying a point with the savings you get from a lower interest rate?

As of today, mortgage interest rates are about 6%.

Let’s use an example of someone who is buying a house with a $400,000 mortgage with no points.

The details:

• $500,000 home value (we’ll use this to calculate equity below)
• $400,000 mortgage loan amount
• 6% interest rate

Now, we’ll compare that to someone with the exact same loan amount and house value, but who bought a point:

• $500,000 home value (we’ll use this to calculate equity below)
• $400,000 mortgage loan amount
• $4,000 paid at closing (1% of the loan amount in exchange for the lower interest rate)
• 5.75% interest rate (note: paying a point creates a .25% lower interest rate on average)

Here’s the cost comparison over 4, 5, 6, 7 and 8 years:

As you can see in the above chart where it says “Difference” (in red), if you buy one point on your mortgage, your costs will be $868 more at the end of four years and $101 more at the end of five years. But in the sixth year of having a new mortgage, buying a point will save you $665.

By the end of year seven, you’ll have saved $1,432, and so on. Each additional year you will continue to save money by buying a point, since you get even more of a cost benefit from the lower interest rate, which lowers your monthly payment.

Important questions to ask yourself

So the big questions you want to ask yourself are: 1) do I have the money to buy the point upfront AND 2) will I stay in the mortgage long enough to benefit by buying a point.

(You can do the calculation I did above by yourself by getting two quotes – one with buying a point and one without – and adding up all the mortgage payments in each scenarios to see when your savings from a lowered monthly mortgage payment outweighs the cost of paying the point upfront.)

Don’t forget to look at the effects on home equity on buying a point

Besides looking at cost, there’s another component you should look at when making mortgage decisions. One that people normally don’t think about. And that is how much home equity each scenario will build. Home equity is the value of your house minus what you owe on it. Equity is the part of your home that YOU own, not your bank. So it’s part of your net worth. Loans with higher interest rates build equity more slowly especially at the beginning due to the effects of amortization.

Next, we’ll take a look at the effect of buying a point on the home equity that you build.

Let’s do an equity comparison for years 4, 5, 6, 7 and 8

If you look at the Difference column in red, every year shows that you have more home equity by paying a point than by not paying a point.

This is because you have a lower interest rate, and due to the effects of amortization, where mortgage monthly payments are front-loaded with interest.

Still, equity gains alone won’t make buying a point worth it, as you can see that after 8 years you have $1,822 more in equity compared with without a point which cost you $4,000.

But, put the cost savings PLUS the equity effects together and you get a fuller picture.

Just take a look at year four in terms of cost. It costs you $800 more to buy a point, but you have $900 more in equity, for example. At year 8, you’ve saved $2,199 in costs AND gained 1,822 more in equity.

So, some may say the true breakeven would occur in year 4, not year 6 since you have more home equity and less debt (smaller remaining loan balance).

(You can find out the equity you’d save for yourself by getting an amortization table for each scenario and comparing the remaining loan balance for different time periods.)

Don’t forget about half points, and more than one point!

Remember, you can usually buy fractions of a point as well as more than one point on your mortgage.

As with buying one point, the key is to ask for two quotes from your lender, one without points and one with points, so you can be sure of what the actual reduction of interest rate is that you’re getting by buying points. As I explain in the above video, it depends on the lender and also the market. A .25% reduction in interest rate per 1 point paid upfront is an average you might expect to see, but by no means the rule.

For more help about whether to pay 1 point on a mortgage

Do you see how analyzing these options can mean saving thousands of dollars over time? Many people don’t do this type of careful comparisons when making financing products, and as a consequence they can overpay by a lot.  Don’t let this be you! 🙂

If you need help, or have more complicated financing questions, I offer a service called a mini-REAFE (real estate asset financial evaluation) where you get an analysis of a discrete financing challenge to make sure you are making the best decision with your most expensive investment, your home.

Does this make sense? If you have a question about what we covered here, please leave a comment below.