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Mortgage credits: what are they and how do they work?

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Of all the cost of home ownership, the mortgage rate is one of the largest, contributing significantly to your monthly mortgage payment and the amount you pay for your home by tens or hundreds of thousands of dollars over the life of your loan. But you do have some control over how much interest you pay.

Buying mortgage credits can help you save money on interest over time while reducing your repayment or the time it takes to pay off your mortgage loan.

What are Mortgage Points?

Mortgage points, also known as discount points, are prepaid interest that you pay at closing in exchange for a lower interest rate on your mortgage loan. While points require more cash upfront, prepaying some of your interest lowers your monthly payment and can significantly lower the overall cost of your loan. That’s why buying mortgage credits is called “buy off your mortgage.

How do mortgage points work?

In most cases, a mortgage point is 1% of your mortgage amount and lowers your interest rate by 0.25%. On a $200,000 loan with 4% interest, one point would cost $2,000 and lower your interest rate to 3.75%.

You don’t necessarily have to buy whole points. For example, you can pay $5,000 to buy 2.5 points on a $200,000 loan and lower your interest rate by 0.625% to 3.375%. While there is no legal limit to the number of points you can purchase, there are limits to closing costs that lenders may charge. For this reason, lenders generally limit points to 4% or less.

Good to know

Mortgage points work the same way you do refinance your house. However, you may not get your down payment back unless your refinancing extends the remaining term of your current loan.

Are Mortgage Points Good or Bad?

Mortgage credits are good under certain conditions, but in others it’s better to stay clear.

Why mortgage credits are good

Here are some ways mortgage credits can work in your favor.

Mortgage Points Can Save You Money on Interest

The best thing about mortgage credits is that they lower the cost of your loan. You can take advantage of that benefit by reducing your mortgage payment or bringing the savings to your principal balance and paying off your loan early.

The mortgage point calculators that can be found on the websites of various lenders show you how this works out in practice. For example, a $200,000 loan with two points lowering the interest rate from 4% to 3.5% would cost you an additional $4,000 at closing, but you’ll save $16,427 over the life of the loan, according to the calculator on the Chase -website.

Mortgage points are tax deductible

When you use the mortgage loan to buy or build your primary home, and that home secures the mortgage loan, the IRS generally allows you to deduct mortgage points you pay them in the same year.

You can also deduct points on a refinancing loan the same year you pay them off, as long as you use the proceeds from the loan to improve your principal home. Even on mortgages with points you cannot deduct in the same year, you are allowed to deduct an assessed portion each year over the life of the loan.

Why Mortgage Points Are Bad

If you’re not careful, mortgage credits can work against you.

Mortgage points mean paying more at closing

It can be a chore for a buyer to come up with extras cash before closing. If that’s true for you, buying points up front would either deplete the cash reserves you could spend on a larger down payment — and thereby lower your interest by lowering your loan amount — or sink into an emergency fund.

It can take a long time to break through

Because you pay interest little by little over the life of your loan, it can take years to break down the lump sum you pay for points up front. This may not matter if you plan to stay in your home until the loan is paid off. Otherwise, use an online points calculator to do the math.

Paying two points, or $4,000, to reduce the interest on a $200,000 mortgage from 4.5% to 4% would cost $1,548 more in the first three years you own the home than it would if you spent that extra $4,000. on your deposit. The breakeven point comes in the fifth year and by year six you would have saved $872. If you sell your home before you break even, the points cost you more than they saved you in interest.

This is an especially important consideration for borrowers who plan to: buy a house with a variable-rate mortgage because the rate discount usually only applies to the initial fixed-rate period. You may be better off with a slightly higher rate for a loan that resets after three or five years.

Are Mortgage Points Worth It?

Mortgage credits are worth it if you have the extra cash and plan to stay in your house long enough to break even. If you plan to sell sooner or can’t afford to lose the money, you can always make additional principal payments later to offset the higher interest you’ll pay if you don’t buy points.

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About the author

Daria Uhlig is a personal finance, real estate and travel writer and editor with over 25 years of editorial experience. Her work has been featured on The Motley Fool, MSN, AOL, Yahoo! Finance, CNBC and USA Today. Daria studied journalism at County College of Morris and earned a degree in communications from Centenary University, both in New Jersey.

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