As if mortgage rates aren’t confusing enough, lenders had to throw discount points into the mix. What are points on a mortgage loan, anyway?
Many lenders now give you the option to buy down your mortgage interest rate through discount points, saving you money over the life of your home loan.
But are discount points really a good deal for buyers? Like many things in the mortgage world, the answers tend to be case-by-case.
Before you hand over a hefty chunk of change to your lender for discount points, it’s best to do your research.
We spoke with John Boyles, Head of Capital Markets at HomeLight, to walk us through the finer points of mortgage points.
Here’s what you need to know.
What are discount points?
“There’s an option where you can, in effect, prepay your interest rate,” Boyles explains. “You can pay points to get a discounted mortgage rate.”
This is, in a nutshell, the concept of discount points. You pay your lender more money upfront to “buy down” your rate (in other words, you’ll get a lower rate than you would have).
Understand that with discount points, there’s always a tradeoff. You’re paying more for the home upfront, in exchange for paying less for your home over the lifetime of your loan.
Of course, that means you need to be in your home long enough for the purchase of discount points to work out in your favor (more on that later).
How discount points work
Typically, one discount point costs 1% of the loan amount (not to be confused with the price of the home) and tends to knock roughly 0.25% off your interest rate. Sometimes, though, the rate reduction can be a bit less.
According to Boyles, you can usually buy up to three mortgage points from your lender and get up to 0.75% off your rate, though some lenders may offer more.
Let’s say you’re buying a home for $200,000. Your down payment is $40,000, or 20%. You’re taking out a mortgage for the remaining $160,000, and your lender offers you a rate of 4.5%.
If you bought one discount point, you’d pay your lender $1,600 — 1% of the loan amount — and you’d get a 4.25% rate instead.
How much can you save with discount points?
Using the example above, here’s an illustration of what you’d pay — and what you’d save — if you used discount points on your mortgage.
Loan amount: $160,000, 30-year fixed
|No points||1 point||2 points||3 points|
|Upfront cost to buyer||$0||$1,600||$3,200||$4,800|
|Monthly mortgage payment||$811||$787||$764||$741|
|Total cost of mortgage over time||$291,851||$283,357||$274,991||$266,755|
|Total saved over 30-year mortgage||N/A||$8,494||$16,860||$25,096|
Know your break-even point
Keep in mind that discount points are a long game. The longer you stay in your home, the more you’ll save.
In fact, if you don’t plan to stay in your home very long, you could actually lose money on discount points.
That’s why it’s a good idea to calculate your break-even point before deciding whether to pay discount points.
A break-even point is the point at which the money you’ve saved each month adds up to what you paid for the discount points in the first place. After you’ve saved what you spent, you’ve broken even!
Using our example above, let’s say you buy one discount point for $1,600. This reduces your monthly mortgage payment by $24 per month.
In this scenario, you’d need to stay in your home for at least 67 months ($1,600 / $24) — or five and a half years — before you’d break even on your discount points. After that, you’d start saving money each month.
The bottom line: If you don’t plan to stay in your home long enough to see your break-even point, discount points are probably not right for you.
The pros of buying points
Discount points can have their pros, especially if you plan to stay in your new home for a long time.
1. You’ll spend less over the lifetime of the loan.
Discount points can save you significant money over the life of your home loan. And the more you pay down your rate, the more you’ll save over time.
Using our example above, buying three points will cost you $4,800 upfront, yet will save you more than $25,000 over your 30-year mortgage. That’s nothing to sniff at!
However, that scenario also requires you to be in your home for 30 years while you pay off your mortgage. Plus, it assumes you’ll never refinance, which many homeowners eventually do.
2. You’ll save more the longer you’re in the house
If you plan to stay in your home for a long time, discount points could work out nicely for you. The longer you stay in your home, the more you’ll save on your mortgage payments over time.
But again, this always needs to be balanced with what you could save by, say, refinancing your mortgage at a lower rate, or investing that extra money in improving your home.
3. Your monthly payments will be lower
One major perk of discount points? Your mortgage payments will be lower each month. And with that, it may seem like discount points are a no-brainer … but not so fast.
Remember that you have to pay discount points upfront at the time your mortgage closes. So if bringing that additional amount of cash to the table means cutting into your down payment, you may be wiping out any monthly savings by adding mortgage insurance to your loan.
If you put down less than 20% on the home, you will be required to pay mortgage insurance (MI). That extra MI cost could override any savings you’d see from discount points — at least until you hit 20% equity on your home, and get rid of your MI payments.
And if you’re able to use that cash to put 20% or more down, you’re likely to be able to get a lower rate and avoid MI without having to pay the discount points.
Best advice: Ask your loan officer to walk you through your options and how they’ll affect your bottom line over time.
4. You could get a tax break
Another upside of discount points is that they can give you a nice tax break, provided you meet certain requirements.
Any interest you prepay on your mortgage is tax deductible on the year you pay it, at least for the first $750,000 you borrow.
However, there are some terms and conditions for that tax break. Make sure you read the fine print and speak with a trusted financial adviser before buying points in the hopes of getting a tax break.
The cons of buying points
Discount points have their fair share of downsides, depending on the specifics of your home purchase.
1. If you aren’t in the house for long enough, you might not break even
Again, discount points are a long game. If you’re uncertain how long you’ll be in your home, it may be too risky to prepay interest.
It’s helpful to look at your break-even point to guide your decision.
How to calculate break-even
Cost of discount points (each one costs 1% of the loan amount)
How much money you’d save each month on your mortgage payment
How many months it will take you to break even.
So, using our example above, if you bought one discount point, you’d break even in around 67 months. The calculation looks like this:
$1,600 / $24 = 66.66 months
Where do you figure out your monthly mortgage payments for each scenario? You can head to a mortgage calculator to run the numbers. This is a great way to conceptualize what using discount points might look like for you.
2. Discount points are pricey
Discount points aren’t exactly cheap, and you’re taking on a bit of risk by using them. Sure, you might save money over time, but maybe you could use that money in a smarter way today.
Could you see more of a return if you invested that money, or put it toward home improvements? Will you need it in a few months to furnish your new home? Is it possible you could save even more money if you refinanced your mortgage in a few years? Would adding it to your down payment lower your rate directly?
These are smart questions to ask yourself. Once you pay discount points, you can’t get that money back, even if you unexpectedly need to sell your home.
Think long and hard about whether a small amount of savings each month is worth it, or whether that money could be better used elsewhere.
3. You may have to make a lower down payment
Down payment and discount points aren’t technically related in the world of mortgage. But, if you only have $30,000 cash to put toward your home purchase, you need to choose wisely where you’ll put that money.
Should you put it toward a larger down payment? Or should you pay some toward your down payment, and set some aside for points?
In many cases, making a larger down payment pays off in the long haul, especially if you can avoid MI payments.
Have your loan officer walk you through your options, and lay out what it would look like to use your cash on a down payment versus points.
Are discount points right for you?
There’s no one-size-fits-all approach for buyers when it comes to discount points. According to Boyles, the best thing you can do is talk to your loan officer.
“A buyer needs to work with their licensed loan officer and make a very educated decision,” he says.
“You need to ask yourself, how long are you going to be in the home? What would you do with that money otherwise? Do you want to spend $5,000 on your mortgage, cause you’re going to be in that home for the rest of your life? Or would you rather spend that money on a new couch when you actually move into your home?”
Perhaps that money could be better spent elsewhere.
Another option is to ask the seller to pay points for you.
“If I personally was buying real estate, I would ask the seller for a credit. If you can get free money from somebody, it’s worth paying the points,” Boyles divulges.
It’s a tactic that’s paid off for him in the past. “I’ve gotten a credit on every deal I’ve ever done. I’ve never purchased a home without the seller paying at least 3%,” he adds.
In fact, Boyles says it’s common for builders to offer points for new constructions as a way to incentivize buyers.
A seller concession may be the best of both worlds for the savvy homebuyer. Plus, it rarely hurts to ask!
Where can you learn about points in your loan?
Your lender must disclose points in both your loan estimate and your closing disclosure.
You can find information about points on Page 2, Section A (under “Loan Costs”) of both your loan estimate and your closing disclosure.
Always check your loan estimate and closing disclosure carefully, and go over all the provided numbers with a fine toothed comb.
Ask your lender to clarify any points of confusion, and walk you through your payment schedule over time. That way, you can make sure discount points are right for you before you buy.
Header Image Source: (Kyle Gregory Devaras / Unsplash)