What You Should Know About Mortgage Discount Points
When your lender quotes an interest rate, it’s often paired with something called mortgage discount points. In fact, your lender may offer you the choice of several interest rates, each paired with a different number of discount points.
Discount points are a kind of prepaid interest: They are an upfront fee paid to your lender at closing to reduce your mortgage interest rate.
Getting a Lower Rate
One discount point typically amounts to 1 percent of the loan amount. So one point on a $250,000 mortgage would equal $2,500, notes a recent article posted on Realtor.com. To purchase the point, you would pay that fee as part of your loan closing cost.
Paying one discount point usually results in an interest rate reduction of 0.125 percent to 0.25 percent on your mortgage, depending on the lender’s terms, says Realtor.com.
Here’s how it works:
Say a lender offers you a 30-year, $400,000 loan at an interest rate of 5 percent with no discount points. Your mortgage payment (excluding taxes, insurance and any other fees) would be $2,147.
In addition, the lender may offer you the same loan at a 4.5 percent interest rate with two points. If you decide to choose this option, you could reduce your monthly payment by $120. But keep in mind, you’ll be paying an extra $8,000 at closing for the two discount points.
Other fees that do not lower your interest rate may also take the form of points, so be sure to clarify the type of point you are paying, cautions the Consumer Financial Protection Bureau (CFPB).
Why You May Want to Pay Points
Is it worth it? That depends on your situation.
“The longer you plan on living in your home, the more sense it may make to pay points. On the other hand, if you’re not sure you will stay in your home for more than a few years, paying points may make less financial sense,” says CFPB.
Using the example above of a 30-year, $400,000 loan, paying two points or $8,000 at closing would save you $120 a month in mortgage payments. But, notes Realtor.com, it would take about 5.5 years before your total mortgage payments have been reduced by more than $8,000 and you started to actually save money. However, if you continued making payments on the loan for the full 30 years, your total mortgage payments would be reduced by $43,394 and your savings would be $35,394 after you deduct your upfront payment of $8,000.
So, if you sell the house or refinance or pay off your mortgage too soon, you won’t recoup the cost of the discount points you paid at closing and can lose money.
Tax Breaks and Other Factors
Another significant factor for some people is that discount points, because they’re a form of interest, are usually 100 percent tax-deductible in the year you buy your home, says Realtor.com.
“Those with heavy tax burdens may find this deduction offsets the cost of buying points to begin with,” notes the article. “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.”
For information on whether you can deduct points from your taxes, CFPB advises borrowers to ask their tax advisor or visit the Internal Revenue Service’s website.
Should You Pay Points?
Paying points is a decision you’ll need to make based on your savings and cash flow at the time of the loan closing and how long you expect to keep your mortgage. Generally, the bigger the mortgage amount, interest rate and mortgage length, the more money discount points will save you, say the experts.
One way to determine whether to pay discount points is to compare the total reduction in your mortgage payments to the cost of the discount points. The total reduction in mortgage payments will depend on the number of monthly payments you make before you sell your home or refinance your mortgage. If you keep your mortgage longer than it takes to recover the cost of your discount points, you would be better off paying the discount points.
“Before you shop, decide what you want to do about points,” advises Jack M. Guttentag, better known as “The Mortgage Professor,” a nationally syndicated columnist and professor of finance emeritus at the Wharton School of the University of Pennsylvania. “If you want to pay points to reduce the rate, you shop rate based on a specified number of points. This has the added advantage of letting loan officers know that you know what you are doing,” says Guttentag.
Source: Realtor.com “Discount Points Explained,” by Craig Donofrio, published Feb. 2, 2015.