Prospective borrowers are often offered the option of paying discount points on their mortgage in return for a lower mortgage interest rate. Discount points are paid at closing with the other closing costs for your mortgage. One way to look at discount points is as a bet. Your mortgage lender is betting that you will keep your mortgage for shorter than or equal to their break-even point and you are betting that you will keep the loan long enough to save money. Investing a little time to understand discount points and the break-even calculation can help you make the right decision with confidence and that can save you real money!
Each discount point is equal to one percent (1%) of the mortgage loan amount. For example, if your mortgage loan amount is $250,000, one point would cost you $2,500 in additional closing costs ($250,000*.01).
The size of the decrease in your mortgage interest rate is strongly influenced by conditions in the financial markets and and thus at any given time it should be relatively consistent between trustworthy mortgage lenders. Paying more discount points will result in a correspondingly lower interest rate. For example, if a discount point lowers your interest rate by 1/4 percent or .25%, two discount points could lower your rate a total of .5%. Use a mortgage calculator to determine the best combination of points and mortgage rates.
If you are buying a home, it may be possible for the seller to pay for your points. This may be in return for requiring a higher purchase price than they would otherwise accept. This can be evaluated in a similar way to the scenarios where you pay for the points. The question would be, does the decrease in interest rate justify the increase in the purchase price of the home. There may be tax implications so you may wish to consult a CPA in addition to your realtor and mortgage loan officer.
The following are factors you should consider when deciding whether or not you should pay discount points:
It may not make sense to pay discount points, if you:
The following example shows you how to calculate the break-even for paying two discount points for a 4.5% interest rate compared to not paying any discount points on a $250,000 30 year mortgage at 5%. To simplify the discussion, it does not consider the impact of the potential tax deduction or the impact of investing the funds rather than paying discount points.
The cost of the discount points, $5,000, divided by the monthly savings of $75.34 shows that it will take approximately 66.4 months or 5.5 years to break-even. Thus, if the borrower plans to keep the loan more than 5 1/2 years it may make sense to pay points to buy down the mortgage rate.