When it comes to residential real estate transactions, closing costs can often seem like a…
When navigating the world of mortgages, you’ll likely encounter a variety of terms and concepts that may seem confusing at first glance. One such term is “points” or “discount points.” While they might sound like something out of a math textbook, discount points are a crucial aspect of mortgage financing that can have a significant impact on your overall costs. In this article, we’ll delve into what discount points are, how they work, and whether they’re a smart choice for your home buying journey.
What are Points on a Mortgage?
Discount points, often simply referred to as “points,” are a form of prepaid interest on a mortgage. They allow you to effectively buy down your interest rate over the life of your loan, resulting in lower monthly payments and potentially substantial savings in the long run. Each discount point typically costs 1% of the total loan amount and can lead to a reduction of about 0.25% in your mortgage interest rate.
How Discount Points Work
Let’s break down how discount points work in a practical scenario. Suppose you’re taking out a $300,000 mortgage with an interest rate of 6.5%. By purchasing one discount point for $3,000 (1% of the loan amount), you might be able to lower (or buy down) your interest rate to around 6.25%. This reduction in interest rate might not seem drastic, but it can translate into meaningful savings over time.
Benefits of Using Discount Points
- Lower Monthly Payments: The most immediate advantage of using discount points is the reduction in your monthly mortgage payments. With a lower interest rate, a significant portion of each payment goes towards paying off the principal amount, helping you build equity faster.
- Long-term Savings: While paying upfront for discount points might seem counterintuitive, it can lead to substantial savings over the life of the loan. The lower interest rate can result in thousands of dollars saved in interest payments over the years.
- Tax Deductibility: In some cases, discount points can be tax-deductible, which could provide you with additional financial benefits. Consult with a tax advisor to determine if you’re eligible for this deduction.
Factors to Consider
Before you rush to purchase discount points for your mortgage, it’s essential to consider a few key factors that will help you decide whether they are the right choice for you:
- Your Financial Situation: Assess your current financial standing. Do you have the funds available to purchase discount points without stretching your budget too thin? It’s crucial to ensure that buying points won’t compromise your ability to cover other essential expenses.
- How Long You’ll Stay in the Home: Consider your long-term plans. If you’re planning to stay in your home for many years, the upfront cost of discount points might be worthwhile due to the accumulated interest savings. However, if you foresee moving sooner than later, the benefits may not outweigh the upfront expense.
- Break-even Point: Calculate the “break-even point.” This is the point at which the money saved on monthly payments due to the reduced interest rate equals the cost of purchasing discount points. If you plan to stay in the home beyond the break-even point, buying points can be financially advantageous.
- Opportunity Cost: Think about what else you could do with the money used to purchase discount points. If you have other high-interest debts or investment opportunities, it might be more beneficial to allocate your funds there.
When to Consider Avoiding Discount Points
While discount points can be a valuable tool, there are situations where it might be more prudent to avoid them:
- Short-term Ownership: If you anticipate selling your home relatively soon, the savings from reduced interest might not have sufficient time to outweigh the upfront cost of discount points.
- Tight Budget: If your budget is already stretched, allocating additional funds to purchase discount points could strain your finances.
- Uncertain Future: If you’re unsure about your long-term plans, such as potential job changes or relocations, the benefits of discount points might not materialize.
But Aren’t Interest Rates Coming Down Soon?
Everyone understands interest rates have gone up a lot in the past year, in large part due to inflation not only here in the US but also abroad. The FED has been raising interest rates in an attempt to arrest rising inflation, which has caused mortgage interest rates to increase from the COVID-fueled historic lows.
From a historical standpoint, interest rates will never (hopefully) return to what they were in 2020 and 2021. It literally took a global pandemic to get to those low rates. Because of this, the likelihood of interest rates getting anywhere near those lows is highly unlikely.
With many areas suffering from a building shortage, home prices have also surged. So while it is possible that mortgage interest rates will go down, the price of homes is unlikely to go down at the same rate. While interest rates may go down from 7% to 6% (a 14% decline), the chances of houses losing that much value is not very realistic.
Waiting for an interest rate decline may put you in a position where you will be losing buying power with the continued increase of housing prices.
Discount points offer an intriguing opportunity to lower your mortgage interest rate and save money over the life of your loan. However, they’re not a one-size-fits-all solution. Careful consideration of your financial situation, long-term plans, and break-even points is essential before deciding whether to purchase discount points.
If you’re uncertain, consulting with one of our mortgage professionals can provide you with personalized guidance tailored to your unique circumstances. Remember, a well-informed decision today can lead to substantial savings in the future.