With the era of historically low interest rates coming to an end, how else can borrowers save money on their mortgage payments? It may be time to consider two other options at your disposal: mortgage points and lender credits.
Both points and credits are tools that a mortgage lender offers to either lower your interest rate or your closing costs. Here’s a guide to how each of them work, and when it might be the right solution for you.
Mortgage Points Explained
Mortgage points are an extra fee that you pay upfront when you purchase a home in exchange for a lower interest rate over the life of your mortgage. This exchange is often called “buying down” your interest rate, which admittedly sounds a little confusing.
Typically, each “point” costs 1% of your loan amount, and decreases the interest rate by 0.25%, says Melissa Cohn, an executive mortgage banker at William Raveis Mortgage. For example, if your mortgage is $200,000 with a 3.25% interest rate, you could pay an extra “point” at closing — in this case, $2,000 — and decrease your interest rate to 3%.
“This is a strategy to think about if you’re thinking of living in the home for a longer period of time,” says Katie Bossler, a quality assurance specialist at GreenPath Financial Wellness, a nonprofit financial counseling organization. The higher upfront cost pays off in the form of less interest paid over the life of the mortgage (typically 30 years), and you’d need to stay in the home long-term to realize those benefits.
Ahead, let’s look at the pros and cons of buying down your mortgage interest rate with points.
Advantages of Mortgage Points
The primary benefit of mortgage points, according to both Cohn and Bossler, is the lower interest rate. That comes in the form of lower monthly mortgage payments, but also has a big impact on the total amount of interest you pay over the life of the loan.
It can also help with your taxes: “A [mortgage] point is tax deductible, so it gives you a little bit of an extra tax deduction,” says Cohn.
Drawbacks of Mortgage Points
The main drawback of mortgage points is the higher closing cost when you purchase a home. Especially in today’s market, where home prices are at record highs, many buyers may not have the extra cash to spare.
Mortgage points could also hurt you if you plan to sell the home before you break even on the extra upfront cost.
“If you don’t think you’re going to be in your home for very long, you’ve paid money upfront you’re never going to recoup,” says Cohn. “If you’re going to be in your property for less than five years, then definitely don’t pay points.”
Bossler also says borrowers should ask themselves: “Is saving that interest on this mortgage best for me?” You might also consider putting the money toward paying off more high-interest debt, or funding future home renovations.
Lender Credits Explained
Lender credits are basically the opposite of mortgage points.
“You are paying less upfront on this loan so that, over time, you’re paying more in interest, but less in closing costs,” says Bossler.
Here’s how it would work: If you’re struggling to come up with money you need for closing costs on a home, a lender could offer you a rebate on those upfront costs, in exchange for a slightly higher interest rate on the mortgage. For example, one lender credit on a $300,000 mortgage could reduce your closing costs by $3,000, but the interest rate would increase by 0.25%.
Lender credits can be a good move for people who don’t plan on staying in a home for very long: You can minimize your upfront costs and sell the home before the higher interest rate negates your savings (also known as the breakeven point).
Advantages of Lender Credits
Lender credits have one big benefit: Saving you money at the closing table.
This is especially helpful if you’re stretching your budget to buy a home in the first place. Credits can also be a good tool if you’ve got a high monthly income (so you don’t mind a higher interest rate and monthly payment) and would rather save on upfront costs.
“The good news is that in today’s world, people have options, and the banks will work with you to help optimize your purchase and your transaction,” says Cohn.
Drawbacks of Lender Credits
There’s always a catch: In exchange for those lower closing costs, lender credits increase your interest rate. That means you’ll end up with a higher monthly mortgage payment and more interest paid over the life of the loan.
“At some point this choice becomes more expensive,” Bossler says.
Cohn also cautions borrowers to make sure a lender isn’t inflating closing costs to the point where lender credits end up hurting you. She advises comparing “apples to apples” with multiple lenders to make sure you understand the base interest rates and closing costs, without points or credits, before adding in those adjustments.
“If it looks too good to be true, it probably is,” Cohn says.
Mortgage Points Vs Lender Credits – Which Should You Choose?
Mortgage points and lender credits each have an important purpose depending on your financial situation. Here’s what to consider when choosing between them:
|Mortgage Points||Lender Credits|
|Mortgage points are a long-term strategy: Using points to lower your interest rate saves you money over the life of your loan.||Lender credits are a short-term strategy: Using credits lowers closing costs and saves money upfront, while increasing your interest rate in the long term.|
|A lower interest rate translates to a lower monthly mortgage payment.||A higher interest rate translates to a higher monthly mortgage payment.|
|If you stay in your home for a long time (past the breakeven point), mortgage points can mean big savings on the amount of interest you pay.||Reducing closing costs can be the difference between buying a home or not. It removes a potential barrier to home-ownership.|
|Mortgage points are tax deductible, which means they can also help you save on your tax bill at the end of the year.||Saving on closing costs could free up money to pay down other (higher interest) debts like credit cards.|
Before you decide on mortgage points or credits, think about how long you plan to stay in the home. That’s key to finding the breakeven point for both scenarios.
Breaking Even on Mortgage Points
The idea of “breaking even” is key to deciding between mortgage points, lender credits, or neither. For mortgage points, breaking even is when the extra money you paid upfront in points is made up in the amount of money you save in mortgage interest. If you’re going to use mortgage points, you want to make sure you’ll stay in the home long enough to break even.
|Zero Mortgage Points||1 Mortgage Point||2 Mortgage Points|
|Cost to Buy Point(s)||–||$3,250||$6,500|
|Upfront Closing Costs||$0||$3,000||$6,000|
|Monthly Payment Savings||–||-$44.21||-$87.64|
|Breakeven Point||N/A||6 years, 4 months||6 years, 5 months|
|Savings Over 30 Years||$0||$12,915.60||$25,550.40|
In both scenarios above, it would take about six years for the savings in interest to catch up with the upfront cost of mortgage points. But over 30 years, the savings really start to stack up.
Breaking Even on Lender Credits
The breakeven point is key to deciding on lender credits, too. If you don’t stay in the home very long, the higher interest rate won’t catch up with you. Here’s how that would work out:
|No Lender Credits||1 Lender Credit||2 Lender Credits|
|Upfront Closing Costs After lender Credit||$6,000||$3,000||$0|
|Breakeven Point||N/A||6 years||5 years, 9 months|
In this table above, the higher the interest rate gets, the higher the monthly payment. However, you pay less upfront in closing costs. In both scenarios above, the upfront savings in the form of lender credits are outweighed by higher interest at around the six-year mark. That means if you stay in your home for more than six years, using lender credits makes your mortgage more expensive overall.