Should I Pay Points and Buy Down My Mortgage?
For most of us, a home represents the biggest purchase we’ll ever make. It’s therefore prudent to familiarize ourselves with the myriad—and often unnecessarily confusing—terms we’re likely to encounter during the mortgage process. In this post, we’ll cover “discount points” (also known as “mortgage points”) and arm you with the tools you need to evaluate whether or not this is a worthwhile purchase.
An overview of discount points
Discount points are a one-time fee paid directly to the lender in exchange for a reduced mortgage interest rate: an exercise also known as “buying down the rate.” Note that these types of points differ from “origination points,” which are fees mortgage lenders charge to process your loan.
Though you typically pay for points at your mortgage closing, some lenders—especially with respect to mortgage refinancing—roll discount points (as well as other closing costs) into your loan amount. This option reduces and sometimes even eliminates the need to shell out additional cash when you close on your new home.
How discount points benefit lenders and borrowers
Mortgage lenders benefit from discount points by receiving cash up front rather than waiting, thus making their loans more profitable. Cash payments also enhance their liquidity, which is especially important as financial institutions are required to hold a significant amount of liquid assets.
Mortgage borrowers, meanwhile, benefit by paying a lower monthly sum as point payments reduce their interest rate.
How discount points work
A single “point” generally lowers your interest rate anywhere from one-eighth (0.125) to one-fourth (0.25) percent and costs one percent of your total mortgage. Thus, if you borrow $100,000, every point you purchase will cost $1,000.
A general rule of thumb re: points
Typically, the longer you reside in your home, the more it makes sense to pay for points. You should therefore only consider doing so if you’re confident you’ll remain there for an extended period of time. This is, of course, assuming you can afford to pay for points in the first place: meaning you’re certain the cash outlay (or higher monthly payment, if fees are rolled into your mortgage) won’t adversely impact your lifestyle.
How to calculate if points are worth buying
To evaluate whether discount points are worth purchasing, you’ll need to determine your “break-even point” (when your accumulated monthly savings are equivalent to upfront fees paid for points).
The math behind this is simple. Simply take the total cost of your points and divide that number by your monthly mortgage payment savings to reveal the number of months you’ll need to stay in your home to break even.
To illustrate, let’s assume your 30-year mortgage is $300,000, your interest rate is 7%, and your lender offers the option of purchasing up to two points for $6,000. Should you choose this option, your interest rate would drop to 6.75%.
As a first step, you should compare your mortgage payments in each scenario. A 7% rate results in a monthly payment of $1,996, while a rate of 6.75% means your monthly payment would drop to $1,946: saving you approximately $50 a month.
Next, dividing the $6,000 price tag by your monthly savings ($50) brings you to 120. This is your break-even point: meaning you’d need to remain in your home for 120 months (10 years) to recoup the money you spent buying down your mortgage rate.
While the math behind points is easy, determining how long you’ll live in your new home is nowhere near as straightforward. It’s therefore crucial to keep in mind that the median homeownership duration is just over 12 years in the U.S. Based on these statistics, it may make sense to buy down your mortgage rate given the provided example—assuming the extra cash outlay won’t impact your desired lifestyle.
Other discount point considerations
Advertised mortgage rates may already include points
When shopping for mortgages, keep in mind that some lenders automatically include points in advertised mortgage rates to make them appear lower than they truly are. You should therefore ask lenders to furnish mortgage rates that don’t include any points or other optional upfront fees: thus making it easier to compare companies.
Points are sometimes tax deductible
Points are considered prepaid interest; therefore, the IRS generally allows you to deduct the full amount of your points in the year you buy them, provided you itemize deductions on your tax returns.
Points are sometimes offered in reverse
Another aspect of points is that lenders may also offer them “in reverse”: meaning you actually receive points from your lender in exchange for paying a higher interest rate. This option—also known as a “rebate”—most often appeals to borrowers who are perhaps low on cash or are applying for low-or no-money-down mortgages.
The bottom line on home loan discount points
It’s important to zero in on two primary considerations when evaluating discount points. The first is affordability, ensuring the cash you use to pay for points won't adversely impact your lifestyle. The second is how long you plan on living in your home. If you’re confident you’ll stay put for a long time (well beyond the break-even point), then paying for points to reduce your mortgage rate is often a worthwhile investment.
FAQs
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In this case, many lenders often dictate this discount is only applicable during the initial fixed-rate period and no longer applies thereafter. This is often concerning, as this loss could occur before you even reach the break-even period. Consequently, it quickly becomes evident that buying mortgage points on an ARM loan may ultimately favor the bank rather than the borrower—proving to be less beneficial in the long run.
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While our company works with various financial institutions, your best bet is to shop around. More specifically, compare the details of at least three lenders’ offers to ensure you’re getting a good deal—ideally throwing a credit union into the mix as many are very competitive in the mortgage space.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to you needs, such advice services must be obtained on your own separate from this educational material.
