Two of the sweetest words in the English language might be “discount” and “point.” After all, everyone loves a discount, and points are usually a pretty good thing whether you’re taking a test, playing football or just using a freshly sharpened pencil. When it comes to a mortgage, though, discount points aren’t as cut and dry. They’re always a good thing, but you can’t be sure whether they’re a good thing for you or a good thing for your lender without digging a bit deeper..
Introducing Discount Points
When you take out a mortgage, some lenders will give you the option of paying discount points to “buy down” your interest rate. For instance, if you get offered a $225,000 mortgage at 4.25 percent, you might have the option of paying a point — $2,250 — to reduce the mortgage’s interest rate to 4 percent. One point is equal to one percent of your mortgage balance. So, as another example, two points on a $175,000 mortgage would cost $3,500.
On the face of it, a discount point might seem like a pretty good deal. If you could pay a dollar to save 25 cents a year, you’d come out pretty far ahead over 30 years. However, lenders aren’t being generous. When you pay a point up front, they have your money no matter what. Your savings come over a period of years and, if you pay your loan off early, you might not get any savings. With this in mind, deciding whether or not to pay points depends on two things: what a point is worth, and how long you will hold on to your loan.
The Value of a Point
The value of discount points varies from day to day. When lenders set their interest rates, they also choose how much they will reduce their rate for a point. The more interest rates go down, the more value a point will be. For instance, one day, paying one percent of a mortgage’s cost as a point could lower the rate from 4.25 percent to 4.00 percent. The next day, though, the lender could cut a point’s value by having the rate only go down to 4.05 or 4.10 percent.
To figure out what a point does for you, compare the monthly payments. For instance, a $225,000 30-year mortgage at 4.25 percent has a monthly principal and interest payment of $1,106.86. Paying a point — $2,250 — to drop the rate to 4 percent would lower the monthly payment to $1,074.18. This saves you $32.68 per month. Dividing the monthly savings into the $2,250 cost of the point shows you that it will take about 69 months to get the money you spent on the point back in monthly savings.
Points and Mortgages
Deciding whether or not to pay a point is relatively simple. From the perspective of saving money, it doesn’t make sense to pay discount points if you won’t hold on to your loan for at least as long as it takes to break even. If you know it takes 69 months to start profiting from a point and you know you’ll sell your house or refinance after 5 years (60 months), you wouldn’t pay the point. On the other hand, if you’re sure you’ll pay off your mortgage in 30 years, paying the $2,250 now would save you $11,764.92 in monthly payments over the life of the loan.
Sometimes, break even points and savings aren’t the only factors you need to consider. If you want to conserve money up front, you might choose not to pay a point even if it’s a better deal for you because you want to save money for an emergency fund or to do work on your home. Also, you might care more about saving a couple of thousand bucks now than saving 20 or 30 or even 100 dollars every month. On the other hand, paying a point for a lower monthly payment might give you more piece of mind or make it possible for you to qualify for a larger loan even if you don’t end up saving money in the long run.
Taxes also come into play, When you reduce your mortgage rate, you reduce your tax deductible mortgage interest. On the other hand, when you pay points in cash, they’re tax deductible right up front on a new mortgage. With a refinance, you spread the deduction for them out over the life of the loan.
Ultimately, while the idea behind discount points is relatively simple, figuring out how they affect you isn’t. An experienced mortgage broker can be your guide to determining if you should pay points and, if so, how many.