Discount Points: To Buy or Not to Buy?
By Sadiya Anjum
‘Points’ is a term that is often thrown around when you are shopping for mortgages. Discount points are basically fees that you pay the lender to reduce your interest rate. Who would not want to reduce their interest rate? But discount points can be worthwhile only for some, not all. Paying points is usually optional except in certain cases such as for bad credit mortgages.
A Point is 1% of the total loan amount which is paid upfront to the lender at closing. With each point you buy, the interest rate is brought down by a certain percentage. This is not really fixed but it is generally around 0.125. So for one point, the interest rate will come down from say 6.5% to 6.375%. The number of points one can buy varies from lender to lender, but generally you can buy from half a point to about four points or more. The reduction in interest rate is simply because the lender receives the money upfront instead of waiting to collect it over the life of the loan. By paying points, you are reducing your monthly payments.
To decide whether or not paying points makes sense to you, you need to first do some simple math. You have to discover your break even point or the time that is required for you to recover the cost of buying the point. After the break even point, you will benefit every month by saving on the extra interest you would have paid if you had not bought the points.
But first calculate your break even point, as it usually takes about 5 or 10 years to reach it depending on the percentage of reduction in the interest rate and the term period of the loan.
- Find out your monthly payment on a zero point mortgage.
- Find out your monthly payment on a mortgage with points.
- Subtract the lesser (mortgage with points) payment from the higher (mortgage without points) payment. The result is your monthly saving.
- Now divide the amount you paid as points by the result above (saving).
The answer you will get will show you the number of months you must wait to reach break even point. After this period you will actually start benefiting from buying a point. If you stick to your thirty year mortgage, you may actually save thousands of dollars. But here is where the big question comes in – are you really going to stay in this house for so many years? Or will you actually wait for so long before refinancing?
Most people may not stay in a home for 10 or even 5 years, and many more people will at some point consider refinancing their mortgage. If you do move out or refinance before break even point, you do not benefit from having bought points. So you should first consider how long you intend to stay in the home before buying points.
Another aspect which can help you decide the prudence in buying points is checking your amortization schedule for a mortgage with zero points and with points. Your outstanding principal balance may be comparatively lesser if you buy points. But how less will depend on the specifics of your loan. So check an amortization schedule to determine whether there is a significant difference in your loan balance. If there is, it may justify buying points. One definite advantage with points is that they are tax deductible.
It all boils down to how long you intend to keep your loan and stay in the home. This is provided you have enough money to buy points at closing. If you have not made a proper down payment and are being charged with PMI, it may make more sense to utilize your money for the down payment instead of buying points. Or perhaps you are not quite sure of how long you intend to stay, then maybe you would rather spend the money on decorating your home. The situations can be varied and you know yours best. So make your calculations and be wise before buying points.
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