Mortgage Discount Points Explained
When your lender gives you an interest rate, it’s not necessarily the one you have to stick with. You can raise or lower your interest rate by buying something called mortgage points.
There are two types of points: one that lowers your interest rate slightly but increases costs at closing, and one that raises your interest rate slightly but reduces costs at closing. In this post, we’ll address discount points (also known as positive points).
How you use discount points can save you thousands of dollars’s or it could end up costing you a pretty penny. You want to do the former, here’s how.
Discount points are a kind of prepaid interest: You pay your lender an upfront fee at closing for a lower interest rate. One point typically amounts to 1% of the loan amount. So one point on a $250,000 mortgage would equal $2,500.
Lowering your interest rate
The primary purpose of buying discount points is to reduce your interest rate. A point usually amounts to an interest rate reduction of 0.125% to 0.25%, depending on the lender’s terms, although 0.25% is typical.
For example, if you bought a 30-year, $400,000 loan at an interest rate of 5%, you would pay $2,147 in mortgage payments a month (not including taxes, insurance, or anything else). Paying two points at 0.25% per point would lower the interest rate to 4.5% and drop the monthly payment to $2,027. You would also need to foot the upfront cost of $8,000 to buy those points at closing.
Using points the right way
You have to consider how long you think you’ll stay in your house. Generally, if you buy points, you want to stay longer to recoup the money it took to buy the points. If you sell the house too soon, you won’t recoup the costs and can lose money.
Let’s go back to the above example of the 30-year, $400,000 loan. The two points for $8,000 at closing saves you $120 a month in mortgage payments. It would take about 5.5 years before you recouped that $8,000 and started to actually save money.
However, it would also save you $43,394 in interest over the life of the loan. Deduct that $8,000 in point-buying costs from money saved in interest and you will have actually saved a total of $35,394. Of course, that’s if you see out the life of the loan. If you sell after six or seven years, buying those points wasn’t worth it. Know your future plans and move forward accordingly.
Tax breaks and factors
It’s not just about saving money in interest and recouping costs. Another factor is what you could have done with the discount point money had you invested it elsewhere.
Another significant factor for some people is that discount points, because they’re a form of interest, are usually 100% tax-deductible on the year you buy your home. Those with heavy tax burdens may find this deduction offsets the cost of buying points to begin with.
Plus, it’s not out of the question to have the lender foot the bill and still benefit from it. If you strike a deal in which your lender pays for your points, you can still deduct the cost of those points on your taxes even though you didn’t directly pay for them.
You also have to weigh in your starting interest rate, loan amount, and loan length. Generally, the bigger the mortgage, interest rate, and mortgage length, the more money discount points will save you. Buying points on shorter-term mortgages or those with very low interest rates could yield savings of only a few bucks a month, so be sure to do the math.
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Craig Donofrio lives in New Orleans, where he writes about real estate and finance news. He enjoys books, football, Scotch, unusual video games, Southern architecture, and learning new random subjects.