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Should you pay mortgage discount points for a lower rate?

NewCastle Team Dec 27, 2022 9:55:00 PM
mortgage discount points

Paying discount points is a way to lower your mortgage interest rate. Essentially, you pay a lump sum at closing in exchange for a lower interest rate on your mortgage. 

Points allow you to spend more now to save later, which is good if you plan to stay in your home for a long time and can afford the upfront cost. But for most first-time homebuyers, paying points is wasting money.

Whether or not paying points is a good idea depends on your circumstances. In this article, I'll answer some common questions we get from our customers to help you decide.

 

What are mortgage discount points? 

A discount point or "points" is a fee you pay to a mortgage lender to reduce the interest rate on your home loan.

Paying points is an option that allows you to spend more now to save later.

Points increase your loan costs and the money you'll need when buying a home. But, in return for the extra fee, you get a lower rate and monthly payment which could save you money over time.

 

How much do discount points cost?

Lenders calculate points as a percentage of the loan amount. One point equals 1% of the loan amount.

As a rule of thumb, one point reduces the interest rate by a quarter of a percent. For a $100,000, 30-year fixed rate mortgage, 1 point costs $1,000, reduces the rate by 0.25%, and lowers the monthly payment by $15. 

In practice, however, the exact number of points you'll pay to reduce the rate fluctuates because mortgage rates change continuously. So ask the lender for a rate quote for the actual cost. Or, check our mortgage calculator for instant and accurate interest rates and closing costs.

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When should you pay discount points?

We created a decision tree to help you decide whether or not to pay points on your home loan.

  1. Do you have enough money? You'll need enough cash at closing to pay for the down payment and closing costs, including the discount points.
  2. Are points your best investment? Consider improving the property, saving your money, or spending it on something that will give you a better return on your investment. 
  3. Is your rate fixed until you recover the upfront cost? 
  4. Is your down payment 20% or more? The lender will make you pay mortgage insurance if your down payment is less than 20%. Focus on getting rid of mortgage insurance first. 
  5. Will you break even or come out ahead? Calculate the break-even to determine when you'll recover the upfront cost and save money.
 

 

When will you break even by recovering the upfront cost for points?

A simple break-even calculation helps when comparing mortgage quotes.

The break-even point is when the upfront cost of buying discount points equals the accumulated monthly savings from lowering the interest rate. 

Follow these steps to figure out when you will break even:

  1. Ask the lender for a rate quote with zero points. Then ask for a second quote with points so you can see how much they cost.
  2. Calculate the difference between the monthly payments to see how much you'll save each month by paying points upfront. 
  3. Divide the cost for points by the monthly payment difference to see how long it will take to break even.

 

For example, for a $100,000 loan, the lender is offering a mortgage at 5% with no points. One point will reduce the rate by 0.25% to 4.75%.

 

How much will you pay for points? 

Loan amount

Cost

Reduce rate

$100,000 

$1,000

-0.25%

 

How much will you save per month? 

Mo payment  Interest rate
$537 5.00%
$522 4.75%

Mo savings = $15

-0.25%

 

When will the monthly savings equal the upfront cost? 

Cost of Point

Monthly Savings

$1,000

 $15

 

Break-even in 5.5 years.

$1,000 ÷ $15 = 67 months

 

The break-even point is in about 5 ½ years. After that, the discount points work to your advantage by saving you $15 per month for the remaining 24 ½ years or until you terminate the loan.

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Why do lenders sometimes require borrowers to pay points for a mortgage?

Depending on your situation, the lender might require you to pay discount points. Certain risk factors increase the cost of a mortgage. They include:

Lenders typically cover the cost by increasing the rate. That's why homebuyers with low scores get higher rates. But sometimes, when a loan has more than one risk factor, and the lender needs help paying for the higher cost, they charge you discount points.

For example, someone buying an investment property with a 680 credit score may have to pay discount points.

If money is tight, consider asking the seller to pay some closing costs to reduce the amount of money you'll need at closing. For most types of loans, the seller can give you as much as 3% to 6% of the property's sales price. Be sure to negotiate the seller's credits upfront when making an offer to buy the house.

 

Where are "points" on the Loan Estimate?

After you apply for a mortgage, the lender will send you an official Loan Estimate. Points are on page 2, under Loan Costs, in section A. Origination Charges.

Origination Charges are the lender's fees, including any points you'll pay to the lender at closing. 

When comparing Loan Estimates, weigh the total origination charges against the interest rate the lender is offering. Our Loan Estimate Explainer will help you compare offers and lock in the best deal on a mortgage. 

Mortgage discount points loan estimate closing cost details

 

Check out our mortgage calculator. View current interest rates and closing costs. You'll feel better knowing how much a home will cost.

View current rates

 

 

Jim Quist NewCastle Home Loans
JIM QUIST
President and Founder of NewCastle Home Loans. Jim has been in the mortgage business for 20+ years.

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