When you shop for a mortgage, there are many different terms that will be thrown around at you. Among those terms, you will hear the word discount points. The word “discount” likely makes you perk up, because who does not want a discount on their mortgage? The truth is, the discount is actually a charge towards your mortgage, that you must pay up front. If you choose to pay this fee, however, you are benefited with a lower interest rate. Typically for every 1 point you pay, your interest rate goes down 1/4th of a percentage point. One point is equal to 1% of the loan amount; for example, a $200,000 loan would mean that 1 point would equal $2,000. Now that you know what they are, you should consider the reasons that you should pay these points.
How Long will you Stay in the Home?
One of the largest reasons to pay discount points is when you plan on staying in a home for the long run. If this is your forever home or you will stay for at least 10 or more years, then it is usually worth paying the money to pay down the interest rate. This is because you will save enough money over the life of the loan or the time that you live there to pay off the cost of the discount point as well as reap more savings. If you are not going to stay in the home very long, though, paying the ¼ percent higher interest rate might be in your better interest. Before you decide, do the math – determine how much more it would cost you to take the higher interest rate than it would if you were to buy the rate down, making sure you calculate it over the period of time that you see yourself staying in the home.
Do you Have the Money?
Something to consider is whether or not you have the money to pay the discount points up front. In most cases, this money cannot be included in your loan – you have to pay them up front in order to lower your interest rate. For people that do not have a large down payment, this might not be a good option. The money might be better off used as the down payment rather than on the interest rate. If you are close to the minimum down payment, the extra $1,000 or more can help make your loan less risky as lenders look at the loan-to-value ratio as a part of the risk level of your loan – the more you borrower, the riskier you become.
Even if you do have money to put down on the home, but you have other factors that make your loan riskier, such as a borderline credit score or debt ratio, keeping the money you would pay for discount points in a reserve account can help your case. Lenders always look for compensating factors or factors that make your loan less risky. If you are able to save a few months’ worth of mortgage payments in a savings account, it could help convince the lender that you are not as risky as your qualifying factors make you out to be, making it better to keep the money rather than buy the interest rate down.
Pay Discount Points or Not
In a perfect world, you would have an adequate down payment, money in the bank for reserves and still enough money to purchase a discount point or two. You might not even need reserves if your loan application does not pose any type of risk level for the lender. This would allow you to pay the 1 or 2 percentage points that it would take to get your interest rate down, helping you to keep your mortgage payment as low as possible.
In the end, it is up to you to decide whether or not a discount point is worth paying. People that stay in their homes for the long run often find that it is well worth to paying a few points so that they can have a lower mortgage payment for the next 30 years. If this is just a short-term purchase, however, thinking the process through very carefully will help you decide which situation is right for you.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.
