Why Aren’t Mortgage Points More Popular?

by JT McGee

Help me figure this one out.

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:

  1. 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.
  2. 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.

  1. 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.
  2. 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.

Conventional Advice?

Okay, so let’s cut this off. What I mean to say is that if you:

  1. Plan to live in your home for a very long time
  2. Do not plan on refinancing (as you probably shouldn’t, given that rates would have to be at unbelievable lows to make it worthwhile)
  3. 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.

{ 8 comments… read them below or add one }

tom April 3, 2012 at 10:09

An excellent analysis and you are 100% mathematically correct, however, reality of home buying sets in…

2 discount points on the average middle class home of $250,000 costs $5,000, paid up front along with all other closing costs.

Having it be a no-brainer is easier said than done. 20% down = $50,000. Then you add in an extra 10% for discount points for a total of $55,000 + ~$2,500 in closing costs = $57,500.

Again, we are talking about living in your home for a very long time which means you want something you like, which means if you’ve saved for a $250,000 + discount points, if you find something you love for say, $275,000 (which is not entirely unreasonable), you are getting the $275,000 house.

Your new down payment jumps to $55,000. If you want to do discount points that’ll cost you another $5,500 + ~$2,500 in closing fees. This will bring your grand total up to $63,000. $5,500 over your projections w/ discount points.

So, again, your analysis is correct. However, factoring in your assumptions, plus the reality of home buying, plus emotions, plus total upfront costs, it becomes much more than a “no-brainer”. You start to touch on that by saying “the points requires a $2,000 upfront payment for the discount points you purchased. And let’s not forget that”, but you end up forgetting that in your conclusion.

Reply

JT McGee April 3, 2012 at 10:35

Tom, thanks for your thoughts! So let’s alter the conclusion to include only well-financed borrowers who have the cash to put up to make the deal. My numbers are based on the assumption that its a down payment vs. mortgage points.

In this example, points essentially provide for a 17.6% return on your investment when calculated on the annual difference between the two mortgage payments. It should be very easy to find capital at that rate in a quantity large enough to pay for points but small enough not to affect a mortgage approval.

So, if we change the conclusion, we agree that points are a spectacular investment in a perfectly logical world. So, I guess the answer is that points are not popular because of emotional home buyers. I’m working with Dave Ramsey’s operating system for personal finance and home purchases. If you were to follow his plan, he would recommend the traditional plan outlined above, minus the discount points. (He’s not a fan of any kind of points.) If you are following allowing with rules 1, 2, and 3, then rule 4 (buy discount points!) should be the next logical step.

If I were buying a home right now, and had many of the same goals as many homebuyers, I would purchase it with 20% down and purchase 4 points, which I understand to be the IRS limit for the mortgage interest tax deduction.

Are we in agreement here?

Reply

JT McGee April 3, 2012 at 10:42

Secondary thought: borrow from a 401k. Again, this requires that you’re a well capitalized buyer who has his or her stuff together, but I would find it difficult to pass up a 17% return on my investment capital when I already have investment capital stored elsewhere.

Reply

tom April 4, 2012 at 08:17

Hmmm… I agree with your 1st reply completely, but not to borrow from a 401k.

I tax issue with the double taxation of my hard earned money. A 17% return won’t cover that loss.

Reply

JT McGee April 4, 2012 at 08:37

Double taxation on 401k loans is a myth. If you compare a 401k loan to any other type of financing, there really is no difference. Most any loan you would use for this maneuver is not tax-deductible. Neither is a 401k loan. It’s the exact same thing.

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tom April 4, 2012 at 09:12

You’ll have to explain that one to me.

When you pull the loan money out of the 401(k) you pay taxes on it. When you repay the 401(k) loan, you are paying it back with after tax income. Am I missing something else?

Reply

JT McGee April 4, 2012 at 09:50

You don’t pay taxes on a loan from a 401k. Loans are not income.

Hmm, this will work better. I couldn’t do these examples as quickly as I can reference them: http://www.mymoneyblog.com/double-taxation-and-the-real-reasons-401k-loans-are-bad.html If you want concrete examples of how this works, the same blog has another post on the topic that runs through 3 scenarios: http://www.mymoneyblog.com/better-example-against-double-taxation-of-401k-loans.html

Given the choices, you really only pay double taxes on the loan interest you pay yourself. You can borrow from a bank and pay the loan back with post-tax cash, or borrow from your 401k and pay it back with post-tax cash.

This is another one of those wretched personal finance beliefs that is not founded in mathematics, but erroneously repeated time and time again.

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funancials April 4, 2012 at 12:19

I believe its just the now vs later effect. Why do something now when I can do it later? Do I want to pay $2000 now? Not really. I know it will save me later but I mean, its 30 years from now. I’ll worry about that later.

These are the thoughts of the average human.

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