Anyone thinking about getting a home loan wants a low interest rate, but not everyone will qualify for one. Assuming that the lender doesn’t want to negotiate a lower rate, there’s one more option borrowers should know about: discount points, also referred to as mortgage points.
What Are Discount Points?
Defined as a fee a borrower can pay to a lender to get a lower interest rate, discount points can be used to reduce mortgage payments by a certain amount. Why are lenders willing to offer a lower interest rate in exchange for an upfront payment? Simply because they receive a lump sum of money at the closing, which means that they don’t have to wait to collect the interest as borrowers make payments. The more points a borrower pays, the lower the interest rate and monthly mortgage payments.
Are Discount Points Worth It?
Whether or not mortgage points make sense for a borrower depends on specific factors, such as the interest rate the borrower qualifies for, lender’s willingness to negotiate the rate, the loan term, and how long the borrower intends to stay in the house. If the homeowner plans to move within several years or refinance his mortgage, paying points doesn’t really make sense. Conversely, the longer the homebuyer keeps the loan, the more money he will save.
It’s important to know that a discount point is 1 percent of the loan amount and typically lowers the interest rate by 0.25 percent. Assuming that a borrower qualifies for a 30-year, $150,000 mortgage with a 5.5 percent interest rate, he will have to pay $851.68 per month, which means the total payment on the loan is $306,606 ($156,606 interest). If he buys:
- 1 point, the interest rate will be reduced to 5.25 percent, and the monthly payment will be $828.31, saving the borrower $23.37 per month. In 30 years, the borrower will pay $298,190 ($148,190 interest) and save $8,416.
- 2 points, the interest rate will be reduced to 5 percent, and the monthly payment will be $805.23, saving the borrower $46.45 per month. In 30 years, the borrower will pay $289,883 ($139,883 interest), and save $16,723.
- 3 points, the interest rate will be reduced to 4.75 percent, and the monthly payment will be $782.47, saving the borrower $69.21 per month. In 30 years, the borrower will pay $281,689 ($131,689 interest) and save $24,917.
Considering that the break-even point is 64 months (5.3 years) to recover the cost of discount points, the decision to buy points makes financial sense only if the homeowner will stay in the house for at least five years.
Another important aspect often overlooked is that buying mortgage points has far-reaching implications. For instance, a lower monthly rate would allow a borrower to pay down his mortgage balance faster, which will result in additional savings. Also, discount points can be tax deductible. According to the IRS, a homebuyer can deduct his points if they are marked on the statement and if the home loan is secured by his main residence. The deductibility of discount points also depends on the deductions the person can claim on his federal income taxes and the method of accounting used for income tax purposes. As it can be seen, paying points allows a homeowner to save money in more ways than one.
To make an informed decision, a homebuyer should ask his mortgage broker or loan officer about the options that work best for his situation.