Paying off a mortgage early seems like a really popular idea. I could probably find at least 100 bloggers out of the 900+ who blog about personal finance who are interested in it. Yet, there doesn’t seem to be much love for mortgage points – specifically, mortgage discount points. So let’s break this down with numbers – use a mortgage calculator.
Mortgage Points for Tax Savings
Any conversation about mortgage interest and taxes usually gets a few people riled up. There are plenty of viewpoints on the matter, ranging from “why pay $4,000 in interest to save $1,000” to “yeah but the standard deduction and whatever else.”
But what I don’t understand is why mortgage discount points, which seem like a fantastic deal to anyone who wants to pay off their mortgage earlier, are not a favorite in the land of personal finance.
Let’s work through an example. We’ll start with a $100,000 loan for 30 years with a rate of 5%. For comparison, we’ll then run the numbers on the same 30-year loan with a $100,000 balance with 2 discount points and a 4.5% rate.
Here are the two options available:
- Without points, the $100,000 mortgage costs $536.82 per month, or $193,255.78 over the life of the loan. Drop the 1 to see that you pay a total of $93,255.78 in interest.
- Now, let’s run the numbers with points. The same $100,000 mortgage costs $506.69 per month, or $182,406.71 over the life of the loan. Drop the 1 and you pay $82,406.71 in interest.
Now, obviously the mortgage with the points requires a $2,000 upfront payment for the discount points you purchased. And let’s not forget that.
But notice that without points we’re looking at $93,255 in interest vs. $82,406.71 in interest for a loan with 2 mortgage points. So, basically, if we apply the $2,000 extra cash we have to a larger down payment, we’re going to save about $900 in total interest charges over 30 years at 5%. Alternatively, the same $2,000 “invested” into mortgage points is going to save us about $10,800. That’s a pretty big difference.
Let’s Talk Taxes
The cool thing about mortgage discount points is that they’re prepaid interest. Mortgage point purchases in excess of the standard deduction are tax-deductible. So, if you earn your last dollar in the 25% tax bracket, the $2,000 in mortgage points really has a total cost of about $1500.
Not to mention that mortgage points essentially move a tax deduction forward. So, let’s say you ordinarily have about $2,000 in other standard deductions excluding your mortgage interest. For singles, the standard deduction is $5,950.
Assuming everything stays constant, you will only be able to deduct the interest paid past your first $3,950 in interest, since you would get that deduction anyway.
- Without points we have about 11 years (the first 11 years) in which the interest will actually be large enough to get some kind of deduction. You’ll be able to deduct a total of $574 per year in interest for those 11 years.
- With mortgage points, we’re only going to get about 7 years of deductions, plus the $2000 upfront. So $227 per year for 7 years, plus $2,000 upfront.
Now, these numbers (per year) are averaged, because I don’t want to whip up a spreadsheet for a one time use. Either way, I think we can see how awesome mortgage discount points a really are.
The bottom line is that mortgage points give us $3,589 in tax deductible interest, whereas a mortgage with no points gives us $6,314 in tax deductible interest. Our tax savings in a 25% tax bracket are something like $900 vs. $1500. However, interest paid is $9000 different. So, we’re looking at a real $8400 difference between the two (including a down payment in lieu of mortgage points) for a $2000 investment.
Okay, so let’s cut this off. What I mean to say is that if you:
- Plan to live in your home for a very long time
- Do not plan on refinancing (as you probably shouldn’t, given that rates would have to be at unbelievable lows to make it worthwhile)
- Finance your home with a fixed-rate mortgage
Then you probably should buy mortgage points. That is, if you follow the conventional advice to buy a home, you should be buying mortgage points. I really don’t know why you wouldn’t. It doesn’t make sense not to.
If I were buying a home right now, to live in for a very long time, I’d take the gamble and stock up on mortgage points and be satisfied with my very low rate. I have no intention to ever actually pay off a home mortgage, but for those who do, mortgage discount points are seriously a no-brainer.
This post brought to you by http://www.emortgagecalculator.co.uk.