Are Mortgage Discount Points Worth It?
Published on June 7, 2024 | 7 Minute read
Melanie
Ortiz Reyes
Content Specialist
When securing a mortgage, buyers encounter numerous decisions that can impact the overall cost and terms of their loan, which can get overwhelming. One such decision is whether to pay discount points, a strategy that can lower your mortgage interest rate in exchange for an upfront fee. But is this the right move for you? Let's see!
Understanding Discount Points
Discount points, often referred to simply as "points," are upfront fees paid directly to the lender at closing in exchange for a reduced interest rate on your mortgage. One point is equivalent to 1% of the loan amount. For instance, if you are taking out a $200,000 mortgage, one point would cost $2,000.
Think of it as a way of prepaying interest on your mortgage. This results in a lower monthly mortgage payment and can lead to significant savings over the life of the loan.
How Do Discount Points Work?
As we mentioned, when you pay discount points, you are effectively buying down your interest rate. Here’s how it works:
1. Interest Rate Reduction: Each point you purchase typically reduces your interest rate by about 0.25%, although this can vary depending on the lender and market conditions. Looking to start your mortgage pre-approval process? Connect with one of our lenders here.
2. Break-Even Point: To determine whether paying points is worth it, you need to calculate the break-even point, which is the time it takes for the upfront cost of the points to be recouped through the monthly savings on your mortgage payment.
Calculating the Break-Even Point
To calculate the break-even point, follow these steps:
1. Determine Monthly Savings: Calculate the difference in your monthly mortgage payment with and without points.
2. Calculate the Total Cost of Points: Multiply the number of points by the loan amount to find the total cost.
3. Divide the Total Cost by Monthly Savings: Divide the total cost of the points by the monthly savings to find the break-even point in months.
For example, if paying two points ($4,000 on a $200,000 loan) reduces your monthly payment by $50, the break-even point would be $4,000 ÷ $50 = 80 months, or about 6.7 years.
Pros of Paying Discount Points
1. Lower Interest Rate: Paying points lowers your mortgage interest rate, which can result in substantial savings over the life of the loan.
2. Reduced Monthly Payments: A lower interest rate translates to lower monthly mortgage payments. This can help with budgeting and financial planning.
3. Tax Deduction: Discount points paid on a mortgage for your primary residence may be tax-deductible in the year they are paid, providing an additional financial benefit. However, tax laws are subject to change, so it's important to consult a tax professional for the most current information.
Cons of Paying Discount Points
1. Upfront Cost: Paying points does requires a significant upfront cost, which can be a financial burden for some buyers, especially if they have limited cash reserves.
2. Longer Break-Even Period: If you do not plan to stay in the home for a long time, you may not reach the break-even point, making paying for discount points less beneficial.
3. Opportunity Cost: We have to consider that the money used to pay points could be invested elsewhere, potentially yielding a higher return than the savings from the reduced mortgage interest rate.
When Does Paying Discount Points Make Sense?
1. Long-Term Homeownership: If you plan to stay in your home for a long period, paying points can be advantageous because this means you will have more time to recoup the upfront cost and benefit from the lower interest rate.
2. Ample Cash Reserves: If you have sufficient cash reserves to cover the upfront cost without depleting your emergency fund or other financial needs, paying points can be a good strategy.
3. High-Interest Rate Environment: In periods of high interest rates, paying points to secure a lower rate can result in significant long-term savings. Consumer Finance says the number of homebuyers paying for discount points increased significantly from 2021 to 2023.
When Paying Discount Points May Not Be Ideal
1. Short-Term Homeownership: If you plan to move or refinance within a few years, you may not benefit enough from the reduced interest rate to justify the upfront cost of the points.
2. Limited Cash Reserves: If paying points would deplete your cash reserves or leave you financially vulnerable, it may be better to keep the higher interest rate and avoid the upfront expense.
3. Low-Interest Rate Environment: When interest rates are already low, the additional savings from paying points may not be substantial enough to warrant the upfront cost.
Alternative Strategies
If paying discount points is not the right choice for your financial situation, you can consider these alternative strategies:
1. Larger Down Payment: Making a bigger down payment can reduce the loan amount and, consequently, your monthly mortgage payments without the need for paying points.
2. Shorter Loan Term: Opting for a shorter loan term, such as a 15-year mortgage instead of a 30-year mortgage, typically comes with a lower interest rate and less overall interest paid. According to Investopedia, most homebuyers opt for a 30-year loan.
3. Shop Around: Different lenders may offer varying rates and terms, so it pays to shop around and compare mortgage offers to find the best deal without needing to pay points.
Real-Life Scenarios
To illustrate how paying discount points can play out in real-life scenarios, let's consider these two examples:
1. The Long-Term Homeowner:
- Chelsea plans to stay in her new home for at least 20 years. She secures a $300,000 mortgage at an interest rate of 4.5%. By paying three points (3% of the loan amount, or $9,000), she reduces her interest rate to 3.75%.
- Monthly savings: $140
- Break-even point: $9,000 ÷ $140 ≈ 64 months (or about 5.3 years)
- Since Chelsea plans to stay in her home for a long time, she will benefit from the lower interest rate after the break-even point, making the upfront cost of the points worthwhile.
2. The Short-Term Homeowner:
- Chuck is buying a starter home but plans to move in five years. He considers paying two points on his $250,000 mortgage to reduce his interest rate from 4.25% to 4%.
- Monthly savings: $30
- Break-even point: $5,000 ÷ $30 ≈ 167 months (or about 13.9 years)
- Since Chuck plans to move before reaching the break-even point, paying points would not be beneficial in this case.
Final Thoughts
Deciding whether to pay discount points is a major financial decision that requires careful consideration of your long-term plans, current financial situation, and the overall cost-benefit analysis. While paying points can lead to substantial savings over the life of your mortgage, it is not always the right choice for every buyer.
By understanding how discount points work and calculating the break-even point you can make an informed decision that aligns with your financial goals. Whether you choose to pay points or explore alternative strategies, the key is to ensure that your decision supports your overall financial well-being and long-term objectives.
Ultimately, consulting with a mortgage professional can provide personalized advice and help you navigate the complexities of the mortgage process. This will help ensure that you make the best choice for your unique situation.