Buying Down a Mortgage Rate: When to Pay Discount Points
Discount points are one of the most confusing aspects of the mortgage process for many borrowers. Discount points are fees specifically used to buy down your rate. On a settlement statement, discount points are sometimes labeled "Discount Fee" or "Mortgage Rate Buydown" and one discount point carries a cost equal to one percent of your loan size. Discount points are different than your “origination fee”, the fee that the mortgage lender charges to complete the loan.
A Look at Numbers
To illustrate the points as a percentage of a loan amount concept, let’s look at some numbers. When a loan officer talks about one point on a $100,000 loan, the loan officer is talking about one percent of the loan, which equals $1,000.
For a $300,000 loan, one point equals $3,000 to be paid when you close your loan.
Lenders offer different interest rates on loans with different points. There are three main choices you can make about points. You can decide you don’t want to pay or receive points at all. This is called a zero point loan.
You can pay points at closing to receive a lower interest rate. Or you can choose to have points paid to you (also called lender credits) and use them to cover some of your closing costs.
Let’s run some hypothetical numbers for the analytical (aka Engineer) types. The example below shows the trade-off between points as part of your closing costs and interest rates.
In the example, you borrow $180,000 and qualify for a 30-year fixed rate mortgage loan at an interest rate of 5.0% with zero points you’ll have the following scenario to consider:
You will keep your mortgage for a long time and want to keep the payment as low as possible.
You like the interest rate and will likely hold the home less than 5 years
You want to keep cash to close as low as possible and can afford a higher payment
Now: You pay $675 more at closing
Over the life of the loan: Pay $14
less each month
With no adjustments in either direction,
it is easier to understand what
you’re paying and
to compare prices.
Now: You get
$675 in a lender credit
Over the life of the loan: Pay $14 more each month
*** Rates currently available may be different than what is shown in this example scenario
As you can clearly see, the time you plan on owning the home is a big part of the equation if “break-even” analysis is important to you.
Break-even analysis is simple. Take the cost of the discount points and divide that by the monthly payment savings/cost and you’ll figure out how many months it’ll take you to break-even.
$675 in cost / $14 per month savings will result in a break-even point of 48.21 months.
If you plan on keeping your mortgage for more than 4.1 years, or 48.21 months, then paying the discount points start to make sense. Anything less than that and you might have made the wrong financial decision.
We use the terminology “might have made the wrong financial decision” because a mortgage has tax benefits and consequences that also need to be considered when you run the numbers.
Both interest rate and discount points have tax deductibility benefits for most borrowers. It largely depends on the nature of the occupancy for your new home, the number of properties owned and the amount of interest you are deducting.
It is best to consider all the details when making your decision on whether to pay discount points or not.
Your diligence on applying your personal financial situation to you mortgage choices can be a decision that affects you for 30 years.
Make it wisely.