Should You Buy Discount Points

To Lower Your Mortgage Interest Rate?

 

 

Because buying a home is likely to be one of the largest financial transactions, you’ll complete in life any measure to lower your mortgage payments is worth a second look. Buying mortgage points is one of the most popular ways to lower your interest rate, particularly if you can get the seller to pay those points!

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You could potentially save thousands of dollars over the length of your home loan. Read on to understand how to buy mortgage points, how they work, and the benefits of buying down interest rates.

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What Are Points On A Mortgage?

‘Mortgage points’ is a common industry term that refers to a lump sum paid-in at closing in exchange for a reduced interest rate over the life of the loan. Typically included in the closing costs, the “discount points” reduce your rate which subsequently lowers your mortgage payment. Another way to look at it is that a fraction of the future interest is paid in advance at closing.

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Mortgage discount points are like getting prepaid interest for your home loan. Instead of paying for the interest over time, you incur an upfront cost to reduce the amount due. Because of this, the plan only makes sense if you plan to stay in the home over the long term.

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Typically, there are two types of mortgage points:

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Discount Points 

These are typically the prepaid interest mentioned above. Each point you purchase will lower your mortgage loan by a pre-agreed percentage, normally 0.25% but can be variable based on the borrower and the market conditions.

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Origination points

These are costs associated with mortgage processing. The lender can offer the points to shave off the principal amount. Origination points are less popular in today's real estate market, with most lenders providing no-fee mortgages or a flat fee.

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You may have to negotiate with your loan officer on the origination points, depending on your credit score, real estate down payment, and loan type.

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How Do These Points Work?

As stated above, the discount points you purchase at closing go into paying off some of your future mortgage payments, which reduces the interest on your loan reducing your monthly payment.

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Generally, one mortgage point will lower the interest rate by a quarter of a percentage. This value can vary depending on the lender, loan type, loan term, and the number of points you want to buy.

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Suppose that you want to take out a $200,000 mortgage at a fixed rate of 4.5% with a repayment period of 30 years. Each point would cost $2,000. It would knock 0.25% off the interest rate, lowering it to 4.25%. You can reduce your monthly payments from $1,013.37 to $983.88, saving $49.49 per month.

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Over a 30-year loan term, the savings can compound to $17,816.40 per percentage point. Purchasing multiple points can lower your interest rates even more. This figure is an approximation and may not reflect the prevailing rates.

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How Much Do Mortgage Points Cost?

The price of discount points will likely differ from one lender to another. Ask your lender directly about their current discount interest rate options for your loan based on how much money is paid upfront at closing.

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To figure out when you'll start recouping your money, you can divide the amount paid for the discount point with the monthly savings. For the preceding example, the $2,000 discount point is divided by $49.49 savings in a month to give a break-even point in 40.41 months or about 3-1/2 years.

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How Many Mortgage Points Can I Buy? 

The number of discount points you can purchase when buying a home depends largely on the lender. Most lenders cap the number of points available at 1% to 3% of the loan amount. They also allow fractional point calculation, such as half a discount point that reduces the interest rate by 0.125%. This may not seem like much but amortized over 30 years it makes a difference in how much you pay for your home.

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The choice of the number of mortgage points to lower your interest rate depends on your cash reserves, the type of loan you choose, your cash flow situation, how long you intend to your home and the lender's terms on the dropped percentage per discount point.

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Reasons to Buy Down The Mortgage Rate 

Mortgage points are not ideal for every borrower. Here are some reasons why you might consider using the mortgage points to lower your interest rate:

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Less Interest Over The Life of the Loan

Points are a percentage of the total loan amount, calculated as a one-time purchase rather than an ongoing payment. You can take advantage of the “prepaid interest” to make additional savings in your monthly payments.

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Keep Your Home Past The Break-Even Point 

The longer you keep your home, the more savings you make from your mortgage points. If you plan to live in your house for a long time, the discount points are an excellent way to buy down your interest rates.

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You can make back your investment over the loan term. If you consider reselling or refinancing your home a few years before the break-even point, mortgage points may not be your best option.

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Lower monthly payments by reducing interest 

Mortgage points are an investment that you make in your home purchase. You're essentially paying a fee to lower the interest rate on your loan and save money over the life of your mortgage.

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The amount you'll save depends on how many points you purchase, how long it takes to pay off those points, and what type of interest rate reduction they yield.

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You've Got Cash Available To Pay For Points 

Buying down the interest rate depends largely on the cash reserve you have to complete the transaction. You can use the additional funds from your savings for the down payment and closing costs to purchase mortgage points, consequently reducing the interest rates for the loan.

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You can use a mortgage calculator to find the exact costs of buying discount points.

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Get Tax Deduction Benefits

The Tax Cuts and Jobs Act, which applies for the tax years 2018-2025, allows for the inclusion of mortgage points as tax-deductible on Schedule A, Form 1040. The IRS stipulates borrowers deduct the points proportionally over the life of the mortgage loan.

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The deductions are also limited to the first $750,000 of the loan. Speak to a tax accountant about the implications of the discount points on your taxes.

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Poor Credit Prevents Getting The Lowest Rate 

If the available loan terms cannot lower your rate further, you can use mortgage discount points to reduce your monthly payments. The one-time lump sum amount guarantees a lower rate for your loan over the long term.

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Should I buy down the mortgage rate? 

Before buying mortgage points, you need to consider your existing financial position and the years you plan to spend in your home. If you have extra cash in your reserves, prepaid interest rates are an excellent investment and even better if your Realtor can negotiate the seller to pay some or all of the points. Then, if you are able and disciplined you can take the extra you are not paying on the interest and put on the principal to buy down the principal and build equity that much faster.

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You may also have to determine the strength of the points in reducing your interest rates. You can negotiate with the mortgage lender for a more favorable rate reduction plan. The savings you hope to enjoy should exceed the discount points' cost.

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If you plan on refinancing your home, you should avoid buying the mortgage points. Most refinance loans have a lower interest charge, negating the initial investment on the discount points.