Last week we continued our discussion on mortgages when we went over origination fees and closing costs. When all the posts in the series are complete, you should have an understanding of mortgage types, structure, rates, points, fees, mortgage insurance, and refinancing. This week we are going over mortgage points, also known as discount points.
- 1 – Common Types of Mortgages
- 2 – Mortgage Structure, What is PITI?
- 3 – Interest Rate vs APR
- 4 – Origination Fees and Closing Costs
- 5 – Discount Points
- 6 – Private Mortgage Insurance (PMI)
- 7 – Refinancing
What are Discount Points?
Typically when someone is talking about mortgage points, it’s discount points they are talking about. There are also origination points that some companies use to compensate loan officers, but not all companies use these. Instead of being charged origination points, you’ll see you are just charged an origination fee. So for our purposes, we will focus on discount points. To state it plainly, discount points are prepaid interest. Generally speaking, each point you purchase up front lowers your interest rate by 0.25%. Understanding these points is helpful in decoding advertised rates from lenders. This is because their advertised rates are often based on purchasing points.
So to recap, discount points lower your interest rate by 0.25% per point. Each point will cost a one time upfront charge of 1% the value of the loan at closing. Additionally, let’s make some assumptions using nice round numbers for easy math. You are going to buy a home for $100,000. Your mortgage interest rate is going to be 4.5% on a 30 year loan. You are given the option of purchasing 2 points to lower your rate to 4% (remember that each point is worth 0.25%). All said, you are going to have to pay $2,000 at closing for the points.
Advantages of Discount Points
- Lower interest rate
- Smaller monthly payment
- Quicker building of equity
- Points are tax deductible
- Less interest paid over time
Disadvantages of Discount Points
- Upfront cost during closing
- Less cash on hand to handle unforeseeable expenses
- Could lose money if you refinance or sell too soon
- Monthly savings may not be worth it
- The money may be better spent in investments
Should You Buy the Discount Points?
Honestly, there’s a bit of analysis that needs to be done on your break even time. We will go into break even times in depth in a later post. For now, we will simplify it a bit specifically for the purpose of these points. While we are at it, we can decide how long we need to stay in the house to decide if these points will benefit us. For the purposes of points, your break even point is when you recoup the cost of paying for the points up front. So in this instance, how long will it take you to recover the $2,000 you spend up front through the reduction of your monthly payment.
Quick Math: If you pay $2,000 for 2 discount points at closing to lower your payments by $30 a month, it will take 5.5 years to break even!
Doing some quick math, we know that our $100,000 loan at 4.5% for 30 years is going to cost us $507 per month. The same loan at 4% will cost us $477 per month. This means we save $30 per month, or $360 per year. So buy purchasing the points for $2,000, you are saving $360 per year. When calculating your break even time, it’s more than just looking at the difference of monthly payments. There’s also inflation, how much could you get investing the $2,000 over the same period, your tax bracket (discount points are tax deductible), among other things. So it’s imperative that you speak with a financial advisor and a tax professional before making the decision. If you already have an investment advisor, this would be a good thing to bring up so they could help you calculate your break even times as well.
But we are going to go with easy math and the minimum assumptions just to illustrate our point. So let’s oversimplify and ignore the previously mentioned considerations (which you shouldn’t do, but again, this is just an illustration). It would take you 67 months ($2,000 / $30) or 5.5 years ($2,000 / $360) to have saved enough in mortgage payments to pay for the points. If you know you will not stay in the house this long, you may want to rethink purchasing points. And this goes without saying, but all the considerations I said we are ignoring can drastically change that break even time up or down. So invest in a pro to help you navigate those options.
The most important takeaway is that you need a tax pro and financial advisor before making a decision. My illustration may seem easy enough, but keep in mind there are a lot of other factors that will dictate if the pros outweigh the cons. If this is your retirement home or you know you’re going to be in the house for a decade, it may be worth it. If you are someone who wants to pay off the house as quickly as possible to have no mortgage payments, this could be worth it. Even investors may want to pay points if the rates are low and they want to hold on to the property to rent for a long time.
But always remember, just because something looks awesome doesn’t mean it is in your situation. And if the $30 a month doesn’t seem like it’s worth paying $2,000 upfront, you could be mistaken depending on your circumstances and goals. I can’t stress enough how important it is to talk to a professional before getting your mortgage. You’ll notice that’s a common theme among the past several posts. Don’t get your advice from a real estate agent or mortgage broker on this one. Go talk to a tax pro and/or financial advisor.