Mortgage Discount Points. What Are They and Are They Right for You?
Mortgage Discount Points
What are they & are they right for you?
A mortgage discount point is a fee paid at the time of closing that lowers your interest rate. A lower interest rate sounds like a good thing, doesn't it?! But like everything else, there are pro's and con's. Read below to find out if they may make sense for you.
How Much Do Discount Points Cost?
One discount point costs 1% of your home loan amount. For example, if the amount you're borrowing after your downpayment is $425,000, one point costs $4250.
How much will that 1 discount point lower your interest rate? Well, that depends. The number of points needed to lower your interest rate changes each day, just as the interest rate itself changes.
Generally speaking, you might expect to get .25% interest rate reduction for each point you buy. So 4 points, or 4 % of your loan amount, may lower your interest rate by 1%.
The Pros and Cons of Buying Mortgage Interest Points
There are pros and cons to everything, and points are no different.
Some of the PRO's of buying down an interest rate include:
- Locking in a lower interest rate means you'll have a lower monthly payment as you're paying less interest every month
- With a lower interest rate you'll pay less over the life of the loan.
- You may save on income taxes. Points are considered prepaid mortgage interest, which is tax deductible. You'll want to speak with your tax expert to see if that may apply to you.
All this money saving sounds great, doesn't it?!!
But let's look at the opposite side of those savings. Here are some CON's of buying down an interest rate:
- Points can increase your closing costs by thousands of dollars. Do you want to spend that cash now to save a bit monthly, or could you use those dollars to pay cash for new flooring and kitchen updates, and avoid interest charges on the Home Depot credit card you would have used?
- Buying down your mortgage interest rate with points is really just “pre-paying” interest. If you might sell or refinance before you break even, paying for points might not be worth it.
- If you plan on paying extra on your mortgage to pay off the loan quickly, or refinance at some point in the nearer future, you might not end up saving money.
Doing the Math
Will buying points save you money? You’ve gotta do the math to determine when the upfront cost of the points will be covered by the lower mortgage payments. That's your breakeven point. You just need to know how much you'll be saving each month at the lower interest rate, and the cost to buy down to that rate.
Let's say it will cost you 1.75 points on a $200,000 mortgage to go from a 5.125% rate to a 4.75% rate. And your monthly interest rate savings are $46.
The cost of the points is 1.75% of $200,000, or $3500. So let's divide the upfront cost of the points by the monthly savings to see how many months it takes to break even. $3500/$46 = 76.01 months. So in roughly 6 years and 3 months you'll have saved as much in monthly interest as you paid up front for discount points. Will you be in the home longer than that?
The Bottom Line: Mortgage Points Can Save You Money
Though mortgage points and prepaid interest are right for some borrowers, they don’t make financial sense for everyone. You'll want to assess your budget, down payment, loan terms and future plans before committing to points.
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