If you have ever checked out the current status of mortgage interest rates, you may have seen the average points listed next to the rates. What are these points and how do they affect your interest rate?
Points Defined
Mortgage points, or discount points, are upfront fees paid to your lender that allow you to “buy down” your interest rate on your home loan. The idea is that you are prepaying some of the interest on the mortgage, which gives you a lower rate. The more points you pay, the lower your interest rate will be. One point is equal to 1% of the total mortgage loan amount. For example, one point on a $100,000 loan would be $1,000. While the rate varies from lender to lender, each point paid can buy down your rate by about 0.25%.
Break Even Point
Before buying any points, it is important to figure out your “break-even point” – how long it will take for your monthly savings to equal your upfront payment. For0 example, if you pay $4000 in points at the beginning of your loan in order to save $60 a month on your payments, it would take roughly 67 months to break even. That means you would need to stay in your home for at least five-and-a-half years in order to realize any savings from paying that amount of points.
When Should I Pay Points?
Paying for points makes the most sense when you plan to stay in your home for a long time. That allows the upfront cost to be outweighed by the monthly savings eventually. If you intend to buy a home and only stay for a few years, points are not usually worth the price. Any monthly savings would not be realized after factoring in the initial points investment.
In some cases, buying mortgage points could give you a tax benefit. As long as your home purchase meets certain requirements, your points are tax deductible. If this is helpful to your overall financial situation, paying points might be a good choice for you.
If you are trying to decide between making a full 20% down payment or paying some points for a lower interest rate, you should realize that without a full down payment you will be required to carry private mortgage insurance (PMI) which could negate any interest rate savings for several years. Be sure to carefully calculate the costs of each choice.
For those taking out adjustable rate mortgages (ARMs), it is important to know that points usually only provide a discounted rate during the initial fixed-rate period (typically 5 years.) You should pay points on an ARM loan, only when your break-even point will fall significantly before the fixed-rate period ends.
Paying points may also be a good idea if a family member is gifting you money for your home purchase. In this case, you will have more money at the time of purchase than you will in the future and it may be better to use that money to buy down the rate, making it easier for you to afford the payments on your own.
In certain situations, paying mortgage points can save you money in the long run. Talk to your mortgage lender about the current exchange rate on points and whether paying points is a smart idea for your loan.