Should I Pay Discount Points on my Home Loan?
Return on Investment
I know it seems counterintuitive saying that spending money will save you money, but that’s exactly how discount points work.
Discount points give you an opportunity to pre-pay interest on the loan, which results in being able to secure a lower interest rate for the life of the loan.
Unfortunately, there is not a standard “buy down” cost schedule when it comes to discount points. Depending on the market at the time you are ready to lock in your interest rate, the cost of the buy down will vary.
If your lender is transparent with you and gives you the ability to choose your interest rate, you might see something that looks like this.
This is a snap-shot of what a mortgage lender see when looking at interest rates showing the cost, or credit based on a FHA 30 year fixed mortgage.
You will also notice that the price changes depending on whether you lock the interest rate for 15, 30 or 45 days.
In this example, the interest rate appears on the left side in BOLD. Moving the the right, you will see either a cost, or discount points that you can pay to buy down the interest rate, or you will see a number in parenthesis.
When the number appears in parenthesis, this means that the lender will give you a credit to be applied toward closing costs.
Discount Points are an Investment
Because discount points are considered pre-paid interest, you may be able to take certain tax deductions by providing your accountant or CPA with the final closing statement from your loan transaction.
The real investment comes from calculating the break even point, and eventual long term savings of paying up-front discount points to reduce your interest rate for the life of the loan.
The key to realizing the benefit of paying discount points really comes down to how long you plan to stay in the home, or stay with the home loan.
Using the above pricing example, let’s look at using discount points to buy down the interest rate on a $300,000 FHA 30 year fixed loan to identify the point where this investment pays for itself and starts to benefit you, the borrower.
For this example, let’s say you want an interest rate under 4%. To lock in a 3.875% for the next 30 days, the cost is 2.107.
- Loan Amount – $300,000
- Multiplied by
- Discount points – 2.107
- Pre-paid interest cost = $6,321
So the question is, what did I get for $6,321?
How much does it lower my payment going from a 4.25% (with a little money coming back to you to cover closing costs) to 3.875%?
Let’s break this down:
- $300,000 @ 4.25% = $1,475.82 (principle and interest payment)
- compared to:
- $300,000 @ 3.875% = $1,419.71 (principle and interest payment)
What you’re left with is a $56.11 monthly savings. Now let’s divide the investment, $6,321 by the monthly savings of $56.11.
What we’ve got now is the number of months it will take to “break even” on our discount points investment.
Given the above scenario, it would take just under 10 years (112 months) before you will begin to realize an actual savings as a result of paying discount points.
Understanding Life of Loan Savings
The real benefit occurs further down the line after making payments for almost 9 years, and when you look at the life of loan savings (once all payments are made), this is where you really have gather the facts you’ll need to determine if discount points are a good financial decision for you and your family.
If you keep the loan in our example for the entire 30 year term, your $6,321 investment will save you $23,439.60 of interest by the time you own the home free and clear.
Life of loan savings is the biggest contributing factor to determining whether or not you should pre-pay interest, and pay discount points.
In the above example, for instance, FHA mortgage insurance is permanent for as long as you have the loan. It would make sense that as soon as you have enough equity, you most likely want to try to refinance to remove the mortgage insurance.
If you refinance, or sell your home, this directly affects your investment, cutting it short or eliminating the benefit entirely.
Creative Ways to Buy Down Interest Rate
Discount points do not have to come out of your pocket. You can ask the seller to contribute to your discount points, you can ask your real estate agent can provide a credit at closing.
The bottom line is that paying discount points is a great strategy if you are confident that you will not refinance or pay off the loan before you have a chance to realize the long term savings.
If you plan to stay in the home, and keep the loan for more than 7-10 years, you should at least have a conversation with your lender about discount points.
In the end it’s a math question. Do the numbers work?
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