If you’re in the process of buying a home, you’ve probably come across the term “discount points.” But what exactly are they, and how do they work?
Discount points, also referred to as mortgage points, are a way to lower your interest rate on a mortgage loan by paying upfront fees. Each point usually costs 1% of the total loan amount and can reduce your rate from 0.25% to 0.5% depending on the lender and market conditions.
For instance, if you’re taking out a $300,000 mortgage and your lender offers an interest rate of 4% on it, one discount point (or $3,000) could reduce it to 3.75% or two discount points ($6,000) would lower it further to 3.5%.
Discount points can reduce your monthly mortgage payments and save you money over time, but they come at a significant upfront expense. Therefore, it’s essential that you carefully assess whether they are the right choice for you.
Here’s what you need to know about discount points on a mortgage:
How do discount points work?
When applying for a mortgage, your lender will offer you an interest rate based on factors like your credit score, income and current market conditions. If you want to lower that rate, you have the option of paying discount points.
Each discount point costs 1% of the loan amount, so if you take out a $300,000 mortgage with one discount point it would cost $3,000. Typically, paying one discount point lowers your interest rate by 0.25%; so if your lender offers an interest rate of 4% then paying one point will reduce it to 3.75%.
It’s essential to note that discount points are optional and not all lenders provide them. Therefore, you must carefully weigh whether the cost of discount points outweighs any savings on your interest rate.
Discount Point Stats
Recent data indicates the average cost of one discount point is approximately 1% of the loan amount. So, for a $300,000 mortgage, one discount point would cost $3,000.
Discount points can be utilized depending on a borrower’s individual situation and objectives. A survey by the Mortgage Bankers Association revealed that in 2020, around 14% of borrowers chose to pay discount points in order to reduce their interest rate.
Additionally, a study by the Federal Reserve Bank of New York revealed that discount points have become less popular in recent years due to historically low interest rates making them less appealing to borrowers.
It’s worth noting that the tax treatment of discount points has changed in recent years. Previously, they could be fully deducted when paid; however, under current tax law they must now only be deducted over the life of a mortgage loan.
Overall, the decision to pay discount points on a mortgage depends on individual circumstances and goals. It’s essential for borrowers to weigh the upfront expense against potential long-term savings and consult with a mortgage professional before making an informed decision.
When should you consider paying discount points?
Your decision whether or not to pay discount points depends on your individual financial situation and long-term mortgage goals. Here are some factors to take into account:
- Your current financial situation: If you have cash reserves and can afford the upfront cost of discount points, it may be beneficial to pay them in order to reduce your monthly mortgage payments and save money over time.
- Your Long-Term Plans for the Property: If you plan to stay in a property for an extended period, paying discount points could be beneficial. On the other hand, if you anticipate selling soon, paying points may outweigh any savings from reduced interest rates.
- When interest rates are high, paying discount points can be an effective way to lock in a lower rate. Conversely, if rates are low, it may not be worth paying the upfront expense for only a slight reduction in your rate.
Ultimately, the decision to pay discount points depends on your individual financial situation and long-term goals for your mortgage.
What are the benefits of paying discount points?
The primary advantage of paying discount points is that they reduce your monthly mortgage payments and ultimately save you money in the long run. For instance, if you take out a $300,000 mortgage with an interest rate of 4% over 30 years, your payment would be $1,432. If you paid one discount point ($3,000) to reduce this rate to 3.75%, however, your payment would decrease to $1,389) over its life expectancy – saving you $16,560 overall.
Another advantage of paying discount points is that they may enable you to qualify for a larger loan amount. By decreasing your interest rate, you’ll reduce your monthly mortgage payment as well.
Another crucial factor to consider is the break-even point. This is the point at which the cost of purchasing discount points becomes outweighed by savings on monthly payments – in other words, how long it takes for those savings to completely offset the expense. The break-even point can vary based on several factors such as interest rate, discount point size and loan term.
As an example, let’s say you’re purchasing a $300,000 home with a 30-year fixed-rate mortgage at 4.5%. You have the option to pay two discount points at $6,000 upfront to reduce your interest rate to 4% and receive a monthly payment of $1,432.25, while without them it would be $1,520.06. Purchasing discount points would save you $87.81 each month on average compared to not doing so.
Calculating the break-even point involves dividing the cost of discount points by monthly savings. In this example, $6,000 divided by $87.81 equals approximately 68 months or just over 5 and a half years – meaning if you plan to stay in your home for at least 5 and half years, buying discount points may be beneficial. Alternatively, if selling before that point is reached, then there would likely not be enough benefit from investing upfront in points.
It is essential to remember that buying discount points may not always be the best solution for all borrowers. Each borrower’s situation is unique and should be assessed individually. Working with a reliable lender who can offer tailored advice tailored towards your individual needs and goals is key in this regard.
Discount points can help lower your monthly mortgage payments and save you money in the long run. But it’s essential to weigh the upfront cost of purchasing discount points against potential savings on payments as well as what happens if they expire before then? Additionally, working with an experienced and trustworthy lender who understands your individual situation is recommended for making the best decision possible.
