The hottest topic surrounding mortgages in most cases is the interest rate. Everyone wants to know what rate a lender will give them. Sometimes that interest rate comes across in more confusing terms, though. A lender might tell you they can give you a 4.0% interest rate with 2 points. What does that mean? Another lender might quote you an interest rate of 4.5% with 0 points. Unless you know what those points, otherwise known as discount points are and how they affect your loan, you might not know what the right choice is for you right now.
What are Discount Points?
First, let’s discuss discount points. An easier way to look at them is to see them as 1 percentage of your loan amount. If you have a loan amount of $100,000, 1 point is $1,000. This means a lender that quotes you a rate of 4.25% with 1 point on a $100,000 loan will cost you $1,000 to get that rate. If you choose not to pay that point, the lender will likely increase your interest rate accordingly. There is a direct relationship between the number of points you pay and the interest rate. The fewer points you pay, the higher the interest rate and vice versa.
The points to discount your interest rate have nothing to do with origination fees. Even though the Good Faith Estimate or Settlement Statement report both costs as a percentage point, they are two different fees. The discount point pays to “buy down” your interest rate. The origination fee pays for the costs the lender has to pay to process your loan. The origination fee is sometimes all of the fees necessary to process your loan in one fee and sometimes there are additional fees – it depends on the lender.
How does the Bank Benefit?
The bank looks at the fee to bring your interest rate down as prepaid interest. Instead of the bank waiting for you to make your mortgage payments to collect the interest costs, they collect it up front. This is what allows the lender to provide you with a lower interest rate for the loan. Every bank offers a different discount for every point, though. The general rule is 1 point for every .25% on the interest rate, but every lender differs. It pays to shop around to see which lender offers the best “bang for the buck” so to speak.
Determining the Break-Even Point
Not every borrower benefits from paying discount points, believe it or not. It might make sense that a lower rate would benefit everyone, but that is only if everyone planned on staying in the home they purchase for the duration of the loan. If you have any plans to move in the future or you just do not see this home as your forever home, you need to determine the break-even point to determine if paying points is worth it.
The best place to start is thinking of the minimum amount of time you will live in the home. No one can predict the future, but having a good idea will help you. If you know, for example, that you will move in 5 years, you can use that as your break-even point. If you are unsure, pick a safe number of years and use that for your calculation.
Now you want to determine how much money you save over the amount of time you plan to be in the home if you pay discount points. For example, if you save 0.25 percent by paying a point, see how long it will take you to recoup that point. If your loan amount is $200,000, one point equals $2,000. If you save $25 each month with the lower interest rate, it would take you 6.6 years to make up that $2,000. If you do not see yourself staying in the home for longer than 6.6 years, then paying the point is not worth it. If on the other hand, you do not see yourself moving, after 6.6 years, you would start saving $25 per month, which equals a little more than $7,000 in savings in interest over the life of the loan. At that point, paying the points probably seems worth it.
Will you Refinance?
Another factor to consider is whether or not you will refinance in the future. Are you happy with the interest rate that the points will buy you? You have to make sure so that you do not consider refinancing in the future. If you do refinance, your break-even point is null and void and you could end up wasting money paying for those points.
Determine your Future Plans
If you consider paying discount points, you really need to determine your future plans. Is this your first home? If so, is it a starter home? Do you plan on expanding your family? What about your job; do you see yourself staying at the same job for the foreseeable future? Is there a chance for relocation? These are factors you should consider to determine if you should pay for points or not.
Using your best assumptions for the future can help you decide what is right for you. Once you make the decision, you should try to stick as close to the plan as possible. If you do decide to pay for discount points, talk to your tax preparer as they are often tax deductible if you purchase a home. Even if you refinance and pay points, though, you may be able to deduct the points over the life of the loan, giving you a little tax relief as a benefit of paying for the prepaid interest on your loan.