When it comes to getting a mortgage, whether you are buying a home or refinancing, you may come across different lingo that can be pretty confusing to understand. One of those terms that you may encounter is called “discount points” or “points”.
Today, we will dive deeper into understanding mortgage points and how they can impact your overall financing.
What are Mortgage Points?
Mortgage points, also known as discount points, are fees paid directly to the lender at closing in exchange for a reduced interest rate.
Essentially, they are prepaid interest on your mortgage. One point equals one percent of your loan amount. For instance, one point on a $300,000 loan would be $3,000. To make it more simple to understand, one point equals to one percent of the loan amount that you are acquiring.
As a rule of thumb, for every 1 point you pay, you should expect your interest rate to be reduced by anywhere between 0.125 to 0.25%.
Two types of Points - Discount Points vs Loan Origination Points
It’s important to differentiate between discount points and loan origination points.
Discount points are used to lower your interest rate, while loan origination points are a fee charged by the lender for processing and underwriting your loan. Depending on your credit scores, loan type, down payment and other factors, the costs of these points will differentiate.
For example, if you have great credit scores and a sizable down payment, the cost of getting a lower interest rate will be substantially lower than if you had low credit and a low to no down payment.
Likewise, both your credit scores, down payment, loan type and other factors will affect the mortgage origination points. Again, these being a cost for originating your loan in certain loans. For someone who is well qualified, the cost will be lower than a buyer who has minimum qualifications.
What is the PAR Rate and How is it Different from the Interest Rate?
In order to understand the value and the meaning of points, you have to know what the “PAR” rate is.
The PAR rate, or “par value”, is the base interest rate that a borrower can receive without paying any points. This means if you don’t pay any points upfront, your interest rate will be equivalent to the PAR rate. Let’s call it the “free” interest rate to you. You are not paying anything to acquire this rate.
In other words, the PAR rate is the true interest that you qualify for based on many factors, most importantly, market conditions, loan type, loan amount, loan to value, debt to income ratio and credit scores. There are many other factors that influence your PAR rate but these are the most important ones.
Now, when it comes to mortgages, your lender may offer you an interest rate that is either above or below the PAR rate. In this case, if you want to secure a lower interest rate below PAR, you can pay discount points upfront to achieve it.
On the other hand, if you are willing to pay a higher interest rate than PAR, you may receive lender credits that will cover some or all of your closing costs. It’s important to keep in mind that these options have an impact on your overall mortgage payment and the total cost of the loan.
Why should you pay discount points?
Paying discount points can be a great way to save money over the life of your loan. For example, these are some of the main benefits of discount points:
- Lower monthly payments: With a lower interest rate, your monthly mortgage payments will be reduced compared to not acquiring discount points.
- Save money over the long term: By paying upfront for a lower interest rate, you can save thousands of dollars over the life of your loan. Below, I’ll show you an example of how discount points can help you save over the loan term. It’s important to do the math and see if it makes sense for your specific situation.
- Tax-deductible: In some cases, you may be able to deduct the cost of discount points on your taxes. This can potentially provide additional savings during tax season.
How Discount Points Can Save You Money - 30-Year Mortgage Example
Let’s take a look and see how discount points can help you save money when taking out a 30-year fixed rate mortgage for $300,000.
| Option | Loan Amount | Interest Rate | Cost of Points | Loan Payment | Monthly Savings | Lifetime Interest Paid |
|---|---|---|---|---|---|---|
| No Discount Points | $300,000 | 6% | N/A | $1,798.65 | N/A | $347,514.57 |
| 2 Points | $300,000 | 5.5% | $6,000 | $1,703.37 | $95.28 | $313,212.12 |
Over the life of a 30-year mortgage, that one discount point can save you a total of $32,303 in interest payments!
Example 2: How Discounts Points Can Save You Money on a 15 Year Mortgage
This time around, let’s assume that you are more concerned with paying off your loan faster and saving on interest payments.
| Option | Loan Amount | Interest Rate | Cost of Points | Loan Payment | Monthly Savings | Lifetime Interest Paid |
|---|---|---|---|---|---|---|
| No Discount Points | $300,000 | 5% | N/A | $2,372.38 | N/A | $127,028.56 |
| 2 Points | $300,000 | 4.5% | $6,000 | $2,294.98 | $77.40 | $113,096.38 |
As you can see, you would save nearly $14,000 in interest payments over the 15 years but also have a reduced payment by $77.40.
In both examples, it’s apparent that you would have more savings by investing in discount points than not.
What are Origination Points and How are They Different from Discount Points?
As mentioned earlier, origination points are different from discount points. While discount points are paid upfront to lower your interest rate, origination points are a fee that the lender charges for processing and underwriting your loan.
This fee is usually a percentage of the total loan amount and can vary depending on the borrower’s credit score, loan type, and down payment. Unlike discount points, origination points cannot be used to lower your interest rate. Instead, they are a cost that is added on top of your mortgage amount.
Who Benefits from Mortgage Points?
Mortgage points typically benefit long-term homeowners. If you plan to stay in your home or keep the mortgage for a long time, buying points to lower your interest rate can save you money over the life of your loan.
However, if you plan to move or refinance in a short amount of time, say for example, within 2 years, then the upfront cost may not be worth the long-term savings.
Every borrower has a different outlook on their life and financials so it’s best to consult an experienced mortgage lender and find out if buying discount points is something that could benefit you.
Pros and Cons of buying discount points
By considering the pros and cons, you can better determine if investing in mortgage points aligns with your financial objectives and homeownership goals. Now, let’s take a look at these potential benefits and drawbacks:
Pros of discount points
Reduced Interest Rates: Paying discount points lowers your interest rate, which can result in significant savings over the life of your loan.
Tax Deductible: In many cases, mortgage points are tax deductible in the year they are paid, if they meet certain conditions.
Lower Monthly Payments: A lower interest rate means lower monthly payments, making your mortgage more affordable.
Cons of discount points
Upfront Cost: Points require a significant amount of cash at closing, which can be a hurdle for some buyers.
Break-Even Period: It takes time to recoup the costs of buying points. If you don’t stay in your home long enough, you won’t realize the savings.
Less Cash for Other Expenses: Paying for points means less cash for other expenses, like home improvements or emergencies.
Strategies for Using Discount Points
Here are some strategies to consider when debating whether to buy mortgage points:
- Short-term vs Long-term Plans: If you plan to stay in your home for a long time, it may be worth investing in discount points upfront to save money over the life of your loan. However, if you plan to move or refinance within a few years, it may not make sense to pay for points upfront.
- Finances: Consider your current financial situation and whether you have enough cash on hand to pay for points. If you don’t have the extra funds, it may be better to opt for a higher interest rate and save up for potential future refinancing opportunities.
- Interest Rate Trends: Keep an eye on interest rate trends. If rates are historically low, it may be a good time to lock in a lower rate with points. On the other hand, if rates are currently high, you may want to hold off on paying for points and wait for them to potentially decrease before refinancing.
- Calculate the Break-Even Point: This is the point at which the savings from a lower interest rate equal the cost of the points. If you plan to stay in your home beyond this point, buying points can
When should you not buy discount points
Discount points may not be a good option for everyone. Here are some scenarios where buying discount points may not make sense:
- You don’t have enough cash on hand to pay for points.
- You plan to move or refinance in the near future (within 2 years).
- Your breakeven point is too far in the future and you’re unsure if you will stay in your home that long.
- You are already getting a great interest rate without points.
- The difference in monthly payments between no points and paying a discounted rate is minimal or the savings are minimal
In these situations, it may be better to focus on saving up for future refinancing opportunities or investing your money elsewhere. However, make sure to consult with a financial advisor and mortgage lender to determine the best course of action.
How to calculate your breakeven point
Let’s go through an example using the scenario from earlier, and let me show you how you can calculate your breakeven point to determine if buying discount points makes financial sense for you.
On a 30-year Mortgage
If you have $300,000 loan with a 6% interest rate at PAR (remember this is your free interest), the loan’s payment is 1,798.65.
You want to get a 5.5% interest rate and your lender says you have to buy 2 points or $6,000 to be able to get that rate. You’ll now have a payment of $1,703.37.
If you divide your upfront cost of the discount points cost of $6,000 by your monthly savings of $95.28, you get the number of months it will take to breakeven on your discount point purchase (in this case 62.9 months).
This means that after nearly 63 months or roughly 5 years, you will begin to see a positive return on your investment and start saving money overall.
You can now use this example and apply it with any term that you are looking for.
Common FAQs about mortgage points
Do I have to pay for discount points?
No, paying for discount points is optional and only beneficial if you plan to keep your home or mortgage for a long period of time. It’s important to weigh the upfront cost against potential long-term savings.
Can I roll the cost of discount points into my mortgage?
Depends. You cannot roll discount points when you are buying a home, but it is possible if you are refinancing as you can include any costs into the new financing when you refinance your loan
Is it worth it to buy discount points if I plan on selling
Depends on when you are looking to sell. If you are only keeping the property for a short amount of time, it may not be worth it to buy discount points. However, if you plan on keeping the property for a longer period of time, buying discount points can save you money in the long run.
Can I write off discount points on my taxes?
In many cases, you may be able to deduct the cost of your discount points on your income taxes. However, there are specific criteria that must be met for this deduction, and it’s important to consult with a tax professional for personalized advice. You can read more on the IRS code here.
Is buying discount points considered a closing cost?
Yes, buying discount points is considered a closing cost and should be factored into your overall budget for purchasing a home.
Are discount points paid by the seller if I’m buying a home?
No, discount points are typically paid by the buyer unless otherwise negotiated in the sales contract. If the seller is paying for your discount points, then it would be part of your seller-paid concessions, which can go to any part of your closing costs. It’s important to discuss this with your real estate agent when making an offer on a home.
Final thoughts
Buying discount points can be a smart financial decision if you plan to stay in your home for a long period of time and have enough cash on hand to cover the upfront cost. However, it’s important to carefully consider your individual situation and weigh the pros and cons before making a decision. Consult with us at Andes Mortgage to discuss your options and determine the best course of action for your unique situation.
Remember, every situation is different and what works for one person may not work for another. We’re here to help you make an informed decision that aligns with your financial goals. Happy homebuying! Overall, buying discount points can be a valuable tool in saving money on your mortgage over
