Mortgage Points

Mortgage points are amounts a borrower pays a lender in connection with getting a home loan, expressed as a percentage of the loan: one point is one percent of the loan amount. In ordinary use the phrase means discount points, which are paid at closing in exchange for a lower interest rate on the note.

The naming genuinely matters here, because the word is not owned by any one rulebook and the three that use it disagree. On the federal disclosure forms it is narrow. Regulation Z requires that "the points paid to the creditor to reduce the interest rate shall be itemized separately … using the label '____% of Loan Amount (Points)'", and adds that "if points to reduce the interest rate are not paid, the disclosure … must be blank" (12 CFR 1026.37(f)(1)(i)). So on the form, Points means rate reduction and nothing else, and the lender's fee for making the loan is a different line. In the Internal Revenue Code it is broad: IRS Publication 936 states that "the term 'points' is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage" and that "points may also be called loan origination fees, maximum loan charges, loan discount, or discount points", treating all five phrases as names for one thing. And in Regulation Z's high-cost rules the word appears inside "points and fees", which is not a charge at all but an aggregate used as a threshold test.

The first regime: a price, disclosed on a line of its own. A discount point is a payment for a lower rate, and Regulation Z gives it a working definition when it needs one. A bona fide discount point is "an amount equal to 1 percent of the loan amount paid by the consumer that reduces the interest rate … based on a calculation that is consistent with established industry practices for determining the amount of reduction in the interest rate … appropriate for the amount of discount points paid" (12 CFR 1026.32(b)(3)(i)). Two things follow. The size of a point is fixed by arithmetic, so it is comparable across lenders. How much rate a point buys is not fixed by anything: it is the lender's own pricing decision, it moves with the market, and it differs between lenders on the same day. Any figure quoted as the standard rate reduction per point is describing one lender's sheet on one morning.

The second regime: a threshold, not a price. "Points and fees" at 12 CFR 1026.32(b)(1) is a defined aggregate that sweeps in finance charges, loan-originator compensation and certain third-party and real-estate-related charges. Its job is to test whether a mortgage crosses into high-cost status under 1026.32(a)(1)(ii), and it does the same work in the qualified-mortgage rules. A borrower who reads "points and fees" as "the points I paid plus my fees" has misread it, and the consequences of the test belong to the predatory lending entry.

The two senses meet at one provision, and it is the sharpest thing in this area. Regulation Z excludes from "points and fees" up to two bona fide discount points if the interest rate without any discount does not exceed the average prime offer rate by more than one percentage point; and if none were excluded on that basis, up to one bona fide discount point if the undiscounted rate does not exceed that benchmark by more than two percentage points (12 CFR 1026.32(b)(1)(i)(E) and (F)). The logic is that buying down a rate that was already competitive is a genuine purchase, while buying down a rate that was far above the market looks more like a fee dressed as a discount. The exclusion narrows precisely as the starting rate gets worse.

The third regime: prepaid interest, and the tax rule runs opposite to the folklore. Points are interest for federal income tax purposes, and IRS Publication 936 states the default plainly: "you generally can't deduct the full amount of points in the year paid. Because they are prepaid interest, you generally deduct them ratably over the life (term) of the mortgage." Full deduction in the year paid is the exception, and it requires meeting nine conditions together. The loan must be secured by your main home; paying points must be an established business practice in the area; the points paid must not exceed what is generally charged there; you must use the cash method; the points must not have been paid in place of amounts ordinarily stated separately, such as appraisal, inspection, title and attorney fees and property taxes; the funds you provided at or before closing, plus any points the seller paid, must be at least as much as the points charged; the loan must be used to buy or build your main home; the points must be figured as a percentage of the principal; and the amount must be clearly shown as points on the settlement statement. A loan to substantially improve your main home needs only the first six.

Three consequences of that list catch people out. A second home never qualifies: Publication 936 states that points on a loan secured by a second home may be deducted only over the life of the loan. An ordinary refinance does not qualify either, though where part of the refinanced proceeds substantially improves the main home, the part of the points allocable to that improvement can be deducted in the year paid. And on a home equity, line of credit or credit card loan whose proceeds are not used to buy, build or substantially improve the home, the points "are not deductible" at all.

Two smaller rules worth carrying. The funds you provided for the sixth test "aren't required to have been applied to the points" and "can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose", so a deposit committed months earlier can be what makes the deduction available. And where points are being deducted ratably and the mortgage ends early, through prepayment, refinancing or sale, the remaining balance is deductible in the year it ends, with one exception: refinancing with the same lender pushes the remaining balance onto the new loan's term instead.

One dated reference to read around. Publication 936's ninth test refers to the amount being shown on "the settlement statement (such as the Settlement Statement, Form HUD-1)". For most consumer mortgages that form was replaced in 2015 by the Closing Disclosure prescribed at 12 CFR 1026.38. The requirement is that the charge be clearly shown as points on the settlement statement the transaction actually produced.

At the pricing stage the lender offers a rate sheet: a base rate with no points, and lower rates at a stated cost in points. The borrower chooses one. The cost appears on the Loan Estimate as a percentage of the loan amount and a dollar figure on the line labeled Points, inside Origination Charges, and it is paid at closing. It then becomes a tax item, because points are interest.

A hypothetical example of the tax treatment, which is where the arithmetic surprises people. Théo pays $4,500 in points on a $300,000 thirty-year mortgage, so he has paid 1.5 points ($4,500 ÷ $300,000 = 0.015).

If the loan buys his main home and he meets all nine tests, he may deduct the full $4,500 in the year he pays it.

If he does not, say because the house is a second home, the points are deducted ratably over the loan's 360 months instead: $4,500 ÷ 360 = $12.50 a month. If he makes four payments in the first year, he deducts 4 × $12.50 = $50 that year, then 12 × $12.50 = $150 in each full year afterwards.

Suppose he sells in year eight, having made 4 + 84 = 88 payments. He has deducted 88 × $12.50 = $1,100, leaving $4,500 − $1,100 = $3,400 unamortized. Because the mortgage ends, that remaining $3,400 is deductible in the year of the sale. Had he instead refinanced with the same lender, the $3,400 would carry onto the new loan's term rather than being deductible then.

The lesson the arithmetic teaches is that the same $4,500 is worth very different amounts depending on facts that have nothing to do with the rate it bought. Figures are illustrative.

Pros

• The cost is fixed by definition at one percent of the loan per point, so the price side of the trade is directly comparable between lenders.
• The charge must be itemized on its own line of the Loan Estimate and the Closing Disclosure, both as a percentage and as a dollar amount.
• Points are interest for tax purposes, so they are deductible under the rules for home mortgage interest, either in the year paid or over the loan's term.
• Where a loan is prepaid, refinanced or the home is sold, ratably deducted points that remain unclaimed generally become deductible in that year.

Cons

• How much rate a point buys is set by the lender, not by any rule, so the return on the payment is not comparable in the way the cost is.
• The money is spent at closing, when cash is scarcest, and it is not recovered if the loan ends early.
• The tax default is the slow one. Most borrowers assume the full deduction and the general rule is deduction over the life of the loan.
• Points on a second home or on an ordinary refinance can never be deducted in full in the year paid, and points on a home equity or line-of-credit loan not used on the home are not deductible at all.
• The word means three different things across the disclosure forms, the high-cost rules and the tax code, and nothing on the form warns you of that.