Mortgages

What Are Mortgage Discount Points

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

When a mortgage loan is closed, the lender makes thousands of dollars. One of the numerous ways they bring in cash is through what are known as “points,” which are paid by the borrowers in advance.

Is the inclusion of points in the closing charges something you’d rather avoid? When would it be beneficial to pay points to get a better interest rate? Keep reading to learn more about mortgage points.

What Are Discount Points on a Mortgage?

Points on a mortgage are an up-front cost paid by the borrower. 1% of the loan amount is equal to one point. One point, for instance, would be $2,000 on a $200,000 mortgage. It’s easy to understand how rapidly the costs may go up.

Origination points and discount points are the two types of points. The only reason lenders charge origination points is to increase their profit margin. Remember that loan officers are salespeople, and they make money on commission, and many lenders utilize origination points to compensate the loan officer who worked on your loan.

Rewards points, on the other hand, are discretionary. The interest rate on a loan can be “bought down” by paying discount points at the lender’s discretion.

Mortgage Discount Points: How Do They Work?

By choosing to pay discount points, you are making a one-time offer to pay a charge in return for a discounted interest rate.

Take, as an example, the case of a $200,000 mortgage at a 3.5% interest rate. You can reduce the interest rate on your mortgage from 3.375% to 3.25% if you pay one discount point at closing.

More on whether or if this deal makes sense for you is coming up. Multiple points can be paid to reduce the interest rate by a larger amount, a single point can be paid for a smaller reduction, and so on.

There are several reasons why lenders provide you this option. First, most lenders will charge interest up front because they anticipate you will sell or refinance your house within a few years. They anticipate that you will not be a client for as long as would be necessary for the interest savings to outweigh the cost of the first charge.

Further, lenders prefer a guaranteed upfront payment rather than waiting for additional interest payments. Your mortgage lender may never get the defaulted interest if you fail to pay. Also, by accumulating funds at the present time, they may do so in today’s values, rather than having to worry about inflation eroding the purchasing power of their future interest payments.

You should also bear in mind that your loan is not likely to remain with the lender you choose. After the closing, the majority of retail mortgage lenders sell their loan portfolios on the secondary market. However, the buyer in the end is flexible and would rather pay less interest overall if it means saving money on the point.

Should You Purchase Mortgage Points?

Using the same scenario as before, you may pay one discount point to reduce your interest rate from 3.5% to 3.25%. Is it something you ought to attempt?

In fact, there is something close to a “correct” solution to that conundrum. How long it would take for the interest savings to equal the upfront cost of the transaction is something that can be easily calculated.

A $200,000 mortgage with a 3.5% interest rate over 30 years would cost $898 per month. To finance the purchase, you’d need $870 at an interest rate of 3.25 percent, saving you $28 per month. Buying one point would cost you $2,000, therefore it would take you 71 months (about six years) to make your money back. You’d save more than $2,000 in interest over the course of six years before breaking even.

Mortgage Points’ Advantages

There is just one advantage to paying discount points, and that is a cheaper mortgage interest rate.

If you can get by with a smaller payment each month, you’ll spend less overall on debt and interest. Paying a one-time charge to reduce recurring costs is something many individuals are willing to do. Think of it as an investment that will pay off once your savings amount exceeds your initial outlay.

This year’s point expenses can be tax deductible if you itemize your deductions. Points are considered prepaid interest, which means they qualify as a tax deduction if your mortgage interest does.

When Should You Purchase Mortgage Points?

Buying points is only worthwhile if you plan to maintain your loan for more than the payback time.

Inevitably, life’s unpredictability makes it challenging to set goals that far in the future. In two years, you may be offered your ideal career, but it may require you to relocate. In the event of a divorce in the next three years, your spouse may be awarded ownership of the property. You might also conduct a cash-out refinancing in four years if you expect to require more money than your emergency fund would provide.

The opportunity cost of not investing in other ventures while waiting for your interest rate to drop might be substantial. In the above scenario, you would need to wait around six years to recoup your initial investment and begin making a profit. But that doesn’t take into account the return on investment you could have made with that extra $2,000. That $2,000 would have grown to $3,543 after six years, making it the superior investment, assuming a historical average return of 10%.

Discount points are not a good idea for adjustable-rate mortgages because of the high upfront cost (ARMs). After the introductory rate period ends, these loans are meant to be refinanced into fixed-rate mortgages.

For certain reasons, I can see why it could make sense to negotiate a lower interest rate for you. Buying down your interest rate is a prudent investment if you are retired or nearing retirement and intend to age in place. However, the typical homebuyer would be better off placing their savings in the stock market.

Bottom Line

Mortgage points are negotiable, like almost everything else in life.

In example, if you shop about and make lenders compete for your business, you may be able to negotiate lower origination costs. Because they are compensated only through commission, loan officers will give you the most expensive estimated fees and charges.

Additionally, there are situations when you may haggle for a lower price. Instead of accepting a 0.25% reduction in your interest rate for every point you pay, try negotiating for a 0.35% reduction. The shorter your time to break even, the more they lower your interest rate each discount point.

The money might also be used to make a larger down payment, thereby avoiding the need for private mortgage insurance (PMI). You may also put the money you would have spent on points toward index funds in a Roth IRA. Before you know it, you’ll be able to retire with a much larger nest egg.

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