Discount Points Explained
Discount points, what are they and should you buy them? In this week’s Real Estate Tip of the Week, I will discuss everything that you need to know about discount points.
Discount points or mortgage points are mortgage closing costs that can be viewed as prepaid interest in order to lower the interest rate on your mortgage loan. Basically, you are paying money upfront to lower your mortgage interest rate. Each discount point is tax-deductible and generally costs 1% of the loan. One point can lower the interest rate by 1/8% to 1/4%, but typically 1/4%. While this isn’t a requirement for a borrower, it is a way to save money over the duration of the loan.
To show you how discount points work, here is an example. Let’s say your mortgage loan is $100,000 at 4% interest. A discount point would cost $1,000 and would lower your interest rate to 3.75% interest. Using Bankrate’s mortgage calculator, your monthly payment at 4% would be roughly $477. With the discount point, your new monthly payment at 3.75% would be $463. So you would save $14/month and it would take 71.5 months (six years) to break even on the initial $1,000 that you spent for the discount point. This does not account for the money you would save from deducting the money spent on the discount point from your taxes so the breakeven point would be even shorter than six years.
So are buying discount points worth it? Well as seen in the example above, it is important to determine your breakeven point. It took 6 years to breakeven in the example. Thus, it is important to think about how long you plan on staying in your new home. If you plan on moving in a couple of years, buying discount points is probably not a smart financial decision. Discount points are for people who plan on staying in their home for majority of the mortgage loan period. Also, when you purchase a home, you have to spend a lot of money on the down payment and closing costs so you may not have extra money to spend on discount points. Therefore, I wouldn’t advise spending the rest of your savings to buy discount points. It is always good to have a reserve fund to cover an unexpected expense in the future.
Typically, borrowers can buy up to 4 discount points but every lender is different. That is why it is important to shop around for the best mortgage rate as each lender offers something unique.
I want to mention that there are negative discount points which are the opposite of normal discount points. When you acquire negative discount points, your lender gives you a rebate and in turn your mortgage rate increases. Homeowners can use these rebates to pay for some or all of their closing costs. While negative discount points sound tempting, they are not advised unless you do not plan on staying in your new home for a long time and need cash for an emergency fund at the time of closing.
Hopefully you now have a better understanding of discount points. To learn more about the mortgage process, visit our Mortgage 101 page. If you have any other real estate questions, feel free to give me a call at 703-350-8800 or an email at email@example.com.