Discount points on a mortgage are also referred to as mortgage points, and they represent the ability to reduce your interest rate over the life of your mortgage, by paying an upfront fee. A single mortgage discount point can be bought for 1% of the amount of the loan, and are paid for at closing. Not all loans, nor all lenders, offer discount points, so if you think you may be interested in them after reading this article, be sure to ask your lender.
A lower interest rate can save you tens of thousands of dollars through the years of making mortgage payments, but the cost of the mortgage discount points can cause your closing costs to skyrocket. Whether or not mortgage points are worth it in the long run depends primarily on how long you live in the home; if you sell the home or refinance it before you get to the point in your mortgage where you’re actually getting to enjoy savings from the smaller interest rate, then the extra cost at closing probably won’t be worth it.
Surprisingly, some home buyers use mortgage discount points as a way to save money on their taxes. Ask your lender or your tax professional for further details, but mortgage discount points are technically prepaid interest on your mortgage, which is tax deductible in many situations.
However, many people consider mortgage discount points simply as a way to ease tension in their monthly household budget by reducing their monthly mortgage payments. If you’re worried that making your mortgage payment will endanger your budget, paying those upfront fees may allow you to afford a home that your monthly income can reasonably cover.
Mortgage Discount Point Specifics
There’s a lot of misinformation about mortgage points floating around out there, so we want to try to help clear the air. For starters, many people falsely believe that 1 mortgage point is equal to 1% of interest being removed, and that’s not the case. The amount of interest rate reduction that occurs from the purchase of 1 mortgage discount point is different for every lender; interest rate discounts from 0.125% to 0.25% are common for a single mortgage point, but your lender’s interest discount per point could much higher or much lower! It is determined by the lender, and they commonly base it on the type of mortgage you’re getting as well as the prevailing interest rates, meaning the discount amount is likely to vary depending on the market, the mortgage type, and the lender.
Another common misconception is that you can buy enough mortgage discount points to have an interest-free mortgage, and the truth is, while anything is possible, this is very improbable. Most lenders have a maximum number of points that can be purchased; it’s not uncommon to see a cap of 3 points, but the maximum mortgage discount points allowed is likely to vary depending on the other circumstances of the mortgage.
Most lenders allow borrowers to purchase fractional points as well; for example, if 1 mortgage point costs 1% of your loan amount and reduces your interest rate by .25%, then purchasing half of a mortgage point would cost 0.5% of your loan amount and would reduce your interest rate by 0.125%.
Mortgage Discount Points or Larger Down Payment?
The numbers will vary depending on the lender, the mortgage, your financial situation, and many other things, but in general, putting money towards your down payment is preferred, especially if your down payment is less than 20%. A larger down payment does generally get you a lower interest rate, and will also reduce your monthly payment, plus the bigger your down payment is, the more instant equity you have in your home from the start. Remember, in most cases, you’ll be able to drop (or avoid) mortgage insurance once your loan principal is down to 80% of the home’s value, which will save you money as well. Spending money on discount points is simply paying some of your lender’s interest fees ahead of time; there’s no equity investment, and no real benefit, aside from the reduced interest rate.
Should You Buy Mortgage Discount Points?
At first consideration, buying discount points seems like it couldn’t be anything but a good idea… after all, everybody wants lower interest rates, right? But it may not be an ideal solution for everyone, and in some cases, mortgage points are actually a bad idea.
Don’t buy mortgage discount points if…
1. You intend to pay off your loan quickly.
If you are financially able to pay your mortgage off quickly, the purchase of mortgage points may not save much of your money. Mortgage discount points won’t really have a chance to pay off unless you let your mortgage term run at least most of its course.
2. You may sell or refinance your home in the next few years.
Again, mortgage discount points don’t have much of a chance to save you money if most of the term of your mortgage isn’t allowed to play out. It takes several years for the money you spent buying the mortgage points to be paid back in the amount of interest you save on your mortgage, so if you feel that you may be itching to sell your home in less than 5 years or so, purchasing points might not be a good idea for you.
3. It would cause a financial strain.
If you don’t already have enough money set aside to purchase mortgage discount points, then it’s likely that doing so would create a financial strain for you. Reducing the interest rate on your mortgage is good, but not if it compromises the down payment on your mortgage, which is far more important. Even compromising other personal funds such as your savings account, a retirement account, or long-term investment accounts typically aren’t worth the savings you will get from purchasing mortgage points. If buying mortgage points will weaken your financial stability, then simply avoid them. You can still save money on interest by paying extra amounts on your mortgage when you have the ability to do so.
Consider buying mortgage discount points if…
1. You plan on living in your home for a long time.
If you feel reasonably sure that you’ll have the same home, and the same mortgage, for quite a long time, then purchasing mortgage discount points may be something worth considering, as they will reduce the total cost of your mortgage loan. The longer you have the mortgage, the more mortgage points pay off.
2. You’ve got extra down payment funds.
It’s always a good idea to make a 20% down payment when you can, but what if you’ve managed to save up 22.5%? Is that additional 2.5% going to save you more money if you add it to your down payment, or if you spend it buying mortgage points? If this is a question you’re faced with, it’s time to talk to your lender, do some math, and find the answer!
3. You did your homework, ran the numbers, and know it works in your favor.
With every home purchase and every mortgage, there is a point where the cost of discount points is paid back by your reduced monthly loan payments. If you’ve already got your down payment ducks in a row, and your finances won’t be put at risk, and you’re relatively certain that you’ll be keeping this mortgage beyond your break-even point, then go for it!
To wrap things up…
…mortgage points aren’t for everyone, but they are yet another tool you can use to save money on your mortgage, and every tool you’ve got in your mortgage toolbox is worth considering! If you’re unsure, lean on a lender you trust to guide you in the right direction with mortgage points; they can help you crunch numbers and determine what’s at stake to be saved and/or risked. If you don’t have a lender you trust, feel free to contact us today! We’d be happy to answer your questions, and you can even apply for pre-qualification right online!