Should I Pay Mortgage Discount Points?
Understanding The Basics
Unsure if you should buy discount points on your mortgage? Use this calculator to compare the full cost of a loan with discount points to one without them. Generally speaking, points are not a great deal if you plan to sell the home soon, but if you plan to live on the home for many years or perhaps throughout the duration of the loan buying points can save you money.
For fixed rate loans points typically lower the interest rate on the loan by a quarter of a percent. Each point costs 1% of the amount borrowed. On a $260,000 fixed-rate home loan buying 2 points would lower the interest rate about a half of a percent & would cost the buyer $5,200. Adjustable-rate mortgages also offer points, but they only lower the interest cost during the introductory rate period.
Points can be financed in the loan, but doing that drastically increases the amount of time needed to break even, thus if you are buying points it typically makes sense to pay for them upfront.
Some lenders also offer negative points which are an upfront cash payment (usually used to help cover closing costs) coupled with a higher interest rate on the loan. Loans advertised as having no closing costs typically come with negative points.
Still shopping for a home loan? You're in luck, as current mortgage rates with points are shown beneath the calculator.
Current Mortgage Rates For $260,000 Home Loans With Discount Points Included
The following table highlights locally available current mortgage rates. By default 30-year purchase loans are displayed. Clicking on the refinance button switches loans to refinance. Other loan adjustment options including price, down payment, home location, credit score, term & ARM options are available for selection in the filters area at the top of the table.
Understanding Mortgage Points
When you are buying a home, one aspect of the deal to understand fully are mortgage points. Though simple in concept, points and whether/how you will pay for them will definitively impact how much you spend, overall. Points need to be considered as a factor both immediately at closing, and over time on your monthly mortgage payments and overall investment.
It should be noted that in some closings, points are not an option but a requirement of the buyer. In other cases, the buyer has the option to consider different APRs based on the addition of points prepaid to the lender. We are focusing on the latter.
What is a Point?
Discount Points vs Origination Points
Points, sometimes called discount points, are upfront fees paid to lower interest rates at the time of a loan’s origination. Though some lenders will use this term to include any fees involved in closing, generally, mortgage points refer to a specific percentage the buyer will pay the lender to lower the interest rate applied to the loan.
The other type of point, used to cover loan costs, is most commonly referred to as an origination point. While discount points are an option for the borrower, origination points are typically a requirement.
Fixed Rate Mortgages
One percent of the loan amount equals one point, though points do not have to be round numbers. Deals between lenders and borrowers commonly employ 1.25 points, .5 points, 2.375 points or any similar derivative. For example, 1 point on a $200,000 loan would be $2,000, 1.5 points would be $3,000, and so on.
Paying points to a lender should lower your interest rate compared to a zero-point loan of the same type with the same provider. So a lender may structure your $200,000, 30-year loan with choices including paying zero points, paying 1 point, or paying 2 or more points at closing.
Specific amounts and impact on the APR will vary by lender, loan-type and duration of the loan. The deals offered should reflect an interest rate on the loan (APR) that decreases with each additional point (or fraction of a point) prepaid. While it is typically an APR reduction of .25% per point on fixed-rate mortgages, it will definitely vary by lender and offer.
In adjustable rate mortgage (or ARM) loans, a discount point reduces interest rates typically by .375% per point (but varies by lender) and corresponds with the fixed-rate period of the ARM – so a 5/1 ARM would see reduced interest rates for five years, a 7/1 ARM would see seven years affected from prepaid point(s).
Some ARM lenders may also allow you to apply points to reduce the margin, or the amount added to the rate index determining your adjusted rate. This means you could reduce the interest rate for much longer than the introductory period. A margin reduction on a 30-year 7/1 ARM affects the interest rate on the remaining 23 years of the loan, while a rate adjustment would apply to just the first seven years of the same loan.
Comparing Your Options
It is incumbent on each borrower to fully understand how each point will affect the APR and costs of the loan.
Keep Aware – Lenders offers will vary, sometimes greatly. A point or two on one deal is not necessarily equal to a zero-point loan for the same amount from a different loan provider. Arm yourself with research into interest rates, market conditions, federal interest rate trends, and other information that enables you to better see the short and longer term effects of your decision. As with all financial decisions, it is best to consult with a trusted and qualified professional for help.
If comparing loans from multiple different lenders becomes confusing a way to simplify the search is to sort primarily by points or by rate. Then when you get what you are looking for there (say good rate with 1 point), compare the best offers from other lenders at that same number of points.
Benefit to the Lender
Points have an obvious financial benefit to the lender: they will receive a lump sum payment upfront for interest that would otherwise trickle-in over time. For this reason, you can think of points offered being a kind of reflection of the overall strength of the current marketplace.
When the market is strong, lenders may be less willing to extend reduced interest rates whereas a softer trend might inspire them to try more competitive pricing in their offers. If interest rates are high or the buying market is sluggish, points can help lenders to open the field to more qualified buyers.
Benefits for the Borrower
Most experts and advisors will agree that a borrower should consider points if most or all of the following are true:
- There is cash-on-hand to pay for the points (opposed to financing them) and this is in addition to all other associated closing costs
- The borrower plans to spend many years in the home (not flipping it)
- The borrower will own the home beyond the break-even point
Discount points can be tax deductible in the year they are purchased. A borrower also benefits prepaying for interest by lowering their applied interest rate over time. Though the interest rate typically drops only a fraction of a percentage per point, this difference can be felt in each monthly payment and the total amount eventually paid.
For example, a $200,000 loan at 5% for 30 years results in a monthly payment of $1,073.64. If the lender offered you 2 points to get 4.75% instead, your monthly payment is $1,043.29 – saving you $30.35 a month, or $364.20 a year. To determine if such a deal is truly worth it to you, you must calculate the break-even timing.
The Break-Even Point
Understanding the value of points and the effect on your interest rate means you must figure out how many months it will take to recoup your investment. This is known as your break-even point.
The simple math to determine a break-even point is to divide the cost of your points by the monthly savings to reach the number of months it takes to see the full return of investment on the points.
Sticking with our example, each point would cost $2000(1% of $200,000), so the lender’s first deal was 4000(cost of 2 points) ÷ 30.35(monthly savings) =132 (months to reach break-even point).
You can see that this kind of deal is not in the best interest of the borrower. Though it may seem enticing to get .25% less of an APR and save $30 a month, it would take 11 years to recoup the full $4000 investment. Two points would be too much to pay to only reduce the rate .25%. If the borrower were to negotiate for one point instead of two, it would decrease the investment/closing cost and reduce the time to reach the break-even point to 66 months.
A borrower might also be countered with a better reduction in rate, say 4.55% for two points instead, which would result in a monthly payment of $1,019.32, saving $54.32 every month. This makes the break-even point math:
$ for points ÷ $ in monthly savings = # of months to break-even
Recouping the investment of the points in just over six years is much better for the borrower than the initial offer of 11 years, and it took a change of less than half of one percent in APR – the negotiation of one point – to get there.
One more calculation to help you determine the best course of action, is to think about the amount of pure interest paid on top of the principal. Using our example, we’ll assume each loan ran a full 30 years to maturity, resulting in roughly: @5% $186,511 in pure interest, @4.75% $175,586 and @4.55% $166,955. The lowest interest rate here would save you almost $20K over the life of the loan, making the two points or $4000 to get there a shrewd investment, if possible.
Can Points Be Financed?
The short answer is yes, the costs for points can typically be rolled into the financed costs of a loan. However, doing this will create additional time and financial considerations to weigh.
Consider that financing the points will add to your loan balance and the amount of interest paid. You will have an additional break-even point to factor in as well, when the cost of the financed points is repaid in full and the benefit of the reduced rate is reached. A shorter break-even period indicates that the financing could be a shrewd move, where longer periods could change your mind about the value of this effort.
It also assumes the additional costs of financing points do not make the loan exceed the maximum allowed for purchase by Freddie Mac and Fannie Mae. Most experts will agree that if a raised loan insurance premium or increased interest rate results from financing the points, it is probably a deal to think twice about and probably pass by.
Paying cash for the points is almost always going to be a smarter move for the borrower, but not always possible. Financing all or some of that cost is certainly an option worth a full evaluation.
Negative points, also called rebate points, lender credits or yield spread premiums, work in reverse of how the borrower’s discount points do in terms of interest rate. The lender offers incremental increases of the interest rate in exchange for a discounted closing cost to the borrower.
In the same way one discount point equals roughly .25% discounted from the APR, a negative point will ADD this difference in exchange for one percent of the loan’s value applied as a borrower credit to closing costs. You cannot use negative points toward any part of your down payment or cash them out.
Using our example, if a $200,000 loan was being negotiated the lender might offer a deal structured with 1.5 negative points to change the APR from 5% to 5.4%, and credit the borrower $3000 toward closing costs.
- Negative points make more sense for the borrower when there are less cash reserves available to close a deal, and a slightly higher monthly premium is also reasonable. Negative points may be smart for people who are looking to be in the deal for a short time period, such as a home flipper or landlord who is not concerned about the higher monthly mortgage payment over time.
- Negative points make less sense when you are planning to hold on to the property for a long time, as you will have increased monthly premiums for the duration of the loan and end up paying more.
Unfortunately, brokers are not always forthcoming about the availability of rebates or negative point loans and may see it as an opportunity to collect more cash from a sale. Rely on help from your own agent and research into current rates and trends to stay abreast of reasonable rates and parameters.
Negative points can be used by brokers to package what they call no-cost mortgages. In reality, the broker often uses negative points to earn more from the deal and the hidden cost is actually an increased interest rate, undisclosed to the unsuspecting buyer.
Using our example, $200,000 might be offered at 5.8% with zero points at closing, but that feels a bit high to you. You know the current market rate is closer to 5%, but zero points to close is certainly attractive. The same lender offers you 5.5% for one point or 5.25% for two points at closing.
The broker may be using negative points to reach their 5.8% “no-cost” offer, using the rebate it produces to pay down associated costs. The idea of it being a no-cost mortgage is misleading, as you will be paying a higher interest rate than you could likely get otherwise. True, there is no upfront cost, but there is going to be a financial impact felt to reach that definition.
You can see that in all three examples, the broker would not lose money – even on the no-cost offer. Brokers can offer these kinds of deals, obtaining their own needed return from the rebate of negative points – especially if they never tell the consumer that the rebate is happening behind the scenes.
Finding Your Best Fit
Today’s home buyer is going to have a plethora of options to sort and understand. Each lender will be different, and each lender will likely offer you multiple deals to consider. How you determine which direction is best for you will be determined by a few common factors:
- Time: How long to you intend to own the property? Short-term views are often bolstered by negative points, and potentially financing options. If you plan to keep your property for a long time, paying cash for discount points will help while financing negative points would be costly.
- Cash: If you can pay for your discount points at the time of closing, it has a direct and compounding impact to their value over time. This does not negate financing options but rolling the costs of points into the loan is not as desirable as having the cash to pay for them instead. Your cash flow should guide you, both on-hand and to cover monthly premiums.
- Break-even: Will you have a decent break-even point to recoup your investment? If a benefit is countered by too much time to break even, it may be less valuable or not worth it to you.
Looking at each offer in a comparison table also helps you break it down to the basics, comparing your apples to apples:
$200,000 for 30 Years
|$ to close||4000 Credit||2000 Credit||0||2000||4000|
|Monthly Savings||add 61.93||add 30.77||0||30.35||54.32|
|# Months to Break Even||65||65||n/a||66||74|
|Total Interest Paid||$208,808.08||$197,586.67||$186,511.57||$175,586.08||$166,955.58|
Gather more information from trusted sites like Fannie Mae on their sponsored Know Your Options site, or in Freddie Mac's Research Center. Government resources like the CFPB can help, as can the mortgage calculators offered on this site.
Ultimately, whether or not you choose points and exactly how they are paid for depends completely on the particulars of your deal and situation. But knowing specifically how they work will put you in a better position to make a wise, balanced and safe choice in your financing.