Prospective homebuyers may have heard of the option to buy discount points to lower the interest rate on their mortgages. Depending on the expectations of the borrower, buying discount points could be a savvy move or costly mistake.
The decision to buy discount points is often a calculated risk, but many home loan borrowers are confused whether or not it is a smart move.
Such is the dilemma, and a very common one, that MyBankTracker reader Jeff faces when he asked:
“Is it wise to purchase discount points to buy [interest rates] down?”
This can only be answered when knowing how long do you expect to keep the mortgage to the home.
Calculating the Break Even Period
When a borrower buys discount points, the lender offers a reduced interest rate in exchange for an upfront payment, much like prepaid interest. Typically, one discount point means a ⅛ (0.125) to ¼ (0.25) percent reduction of the interest rate. The price of one discount point is 1% of the amount of the mortgage – paid as part of the closing costs.
Generally, Jeff will benefit from buying discount points if he plans to stay in his home for the length of the mortgage. For a more calculated approach, Jeff will have to figure out how long it will take to break even from the costs of buying discount points.
Here an example of this calculation:
- 30-year mortgage loan for $100,000
- Interest rate = 5.00%
- 1 discount point (costs $1,000 = 0.125% reduction)
- Monthly mortgage payment (no discount points, 5.00% interest rate) = $536.82
- Monthly mortgage payment (1 discount point, 4.875% interest rate) = $529.21
- Monthly savings = $7.61
- $1,000/$7.61 = 131.4 months = roughly 11 years
So, assuming Jeff was in the exact situation provided above, it would be a smart move to buy discount points if he expects to live in this home for more than 11 years. For the following 19 years, Jeff would enjoy savings from smaller interest payments. If he bought discount points and sold the home before owning it for 11 years, he wouldn’t be taking advantage of the reduced interest rate and actually end up losing money.
Discount points are also tax deductible for the year that they are purchased.
For Jeff’s specific situation, he can use a mortgage calculator to find out how much he’d save on his monthly mortgage payment and from there, figure out how long it would take for the purchased discount points to break even on savings.
The MyBankTracker Community is great place to receive answers to some of your financial questions but it is always a good idea to consult a professional financial advisor for questions that cater to your personal circumstances.