Should You Buy Down Your Interest Rate?
What Are Mortgage Points?
Mortgage points, also known as discount points, are fees paid by the borrower to lower the interest rate on a mortgage loan. The term "point" refers to percentages - each point is equal to 1% of the loan amount.
Here's how mortgage points work:
- Each point purchased reduces the interest rate by a certain amount, usually around 0.25%. The exact reduction depends on market conditions.
- Points are paid upfront at closing. For example, on a $200,000 loan, 1 point costs $2,000.
- More points = lower rate. So 2 points costs $4,000 but may reduce the rate by 0.5%.
- Points only lower the rate on the specific loan they were purchased for.
Understanding how points work is key to deciding if they make sense for your situation.
How Mortgage Points Lower Your Payment
Let's say you get a $200,000 mortgage with a 30-year term and 5% interest rate. Your monthly principal and interest payment would be around $1,073.
If you pay 1 point ($2,000 on a $200,000 loan) to get the rate down to 4.75%, your new monthly payment would be around $1,028.
While you have to pay the $2,000 upfront at closing, you save $45 per month over the life of the loan by buying the point.
When Does It Make Sense To Buy Points?
Buying points to lower your mortgage interest rate can make financial sense in certain situations. The key is determining the break-even point. This is when the upfront cost of the points is recouped in interest savings over the life of the loan.
We calculate this by dividing the upfront cost by the monthly savings, which gives us the time in months to break-even and begin actually saving.
Using the example above, we have:
$2,000 (Point Cost)
$45 (Savings)
44.444 Months
At the 45th monthly payment, in this example you would begin to see the net benefit of the savings because you've overcome the cost.
Some scenarios where buying points may be to your advantage:
- You plan to keep the mortgage for a long time. With a 30-year fixed rate mortgage, it takes years to break even when buying points. The longer you keep the loan, the more interest savings you accumulate.
- You have cash available to buy points. This allows you to lower your monthly mortgage payment through a lower interest rate. Just ensure your plan leaves enough cash remaining for closing costs and emergency funds.
- You don't anticipate deducting mortgage interest. If you don't itemize deductions, buying points lets you lower interest costs without losing tax deductions.
- Rates are relatively low. When rates are low, paying points gives more room for savings over time since the likelihood of improving your rate with a refinance is lower.
Recoup of Pros and Cons of Buying Points
Buying points to lower your mortgage interest rate can provide significant savings over the life of your loan, but also comes with upfront costs to consider. Some key pros and cons to remember:
Pros:
- Lower interest rate saves money each month and over life of loan, and may help with qualifying for the mortgage.
- Can substantially reduce total interest paid over long-term loans.
- Makes sense if staying in home long-term or not planning to refinance.
Cons:
- Requires larger upfront payment at closing.
- May take years to recoup the upfront costs in savings.
- Not worth it if selling home or refinancing soon.
It's important to consider how long you'll stay in the home and if the monthly savings are worth the initial costs. Crunching the numbers with your Loan Originator can help determine if points make sense for your situation.
Strategies for Deciding on Mortgage Points
When deciding whether to buy points, there are a few considerations to keep in mind:
- Evaluate your break-even timeline. Calculate how long it will take for the monthly savings from a lower rate to offset the upfront cost of the points. Generally, you'll want to break even within a few years before you sell or refinance the home.
- Consider your plans for the home. If you plan to stay in the home long-term, buying points for a lower rate can pay off over time. But if you may sell or refinance sooner, it likely won't be worth it.
- Factor in your financial situation. If you have extra cash available, buying points could make sense. But if paying points would strain your finances, it's usually better to invest or save the money elsewhere.
- Compare to investing/saving. Run the numbers to see if you'd come out ahead by investing the money instead of paying for points. The return on buying points should exceed returns from low-risk investments.
- See if seller credits can help. Some sellers may offer credits, also called seller concessions, that can be used to lower your rate without paying points out of pocket. This can be a way to get a lower rate without affecting your cost.
The Best Approach
Naturally this depends on your unique situation. Crunch the numbers for your timeline, finances, and goals to optimize your strategy.
Buying points can provide big savings, if the math makes sense for your expectations and scenario.
Make sure to discuss this topic in detail with your Loan Originator!